Page 28 - CIMA SCS Workbook November 2018 - Day 2 Suggested Solutions

SUGGESTED SOLUTIONS

Interest rate swap

Definition

An interest rate swap is an agreement where two parties agree to swap a floating stream of
interest payments for a fixed stream of interest payments and vice versa. There is no exchange of
principal.

The swap being offered by Bluetone Bank to Novak is known as a “pay-fixed, receive-floating”
swap. It can be used to fix the interest rate on Novak’s floating rate borrowing.

Advantages of using an interest rate swap

 An interest rate swap can give certainty to a borrower whose borrowings carry a floating
rate of interest. Swapping into a fixed rate means that payments will stay constant even if
base rates change.

 A swap can be used as an alternative to renegotiating the borrowings (say changing the
floating rate borrowings to fixed or vice versa). Entering a swap usually involves less
negotiation and administration.

 A swap is a temporary measure, for a set period of time. At the end of the swap the
company’s borrowing rate reverts to what it was before. This can be important if a
company feels it has a competitive floating rate of interest on its borrowings, but wants to
fix its payments for some reason for a fixed period of time without having to renegotiate all
the terms of the borrowings.

 It is possible to get a better rate of interest through a swap agreement than the company
could get by borrowing the other type of borrowing (fixed rate or floating rate) directly.

Disadvantages of using an interest rate swap

 In direct contrast to the first advantage listed above, an interest rate swap can remove
certainty from a borrower whose borrowings carry a fixed rate of interest! A company
paying a fixed rate of interest would choose to enter the swap this way round if there was
an expectation that base rates might fall.

 Swaps can be difficult to set up if a company needs to find a suitable counterparty to swap
with. However, this problem is normally eliminated by banks, who act as intermediaries to
bring counterparties together.

 The bank will usually charge a fee for arranging the swap.

Application to Novak - the Bluetone Bank swap

According to the letter from Mark Morriss, Novak’s borrowings with Bluetone Bank are currently
subject to a floating rate of (Base Rate plus 140 basis points). This means 1.40% above whatever
the base rate of interest is in Cronland.

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