Case 100Interest rate derivativesWarm up
A mid-market company borrows Rs 200 crore for three years at a floating benchmark plus 2%. Its bank offers a swap to pay fixed 7.1% and receive the benchmark. What is the all-in fixed cost, what are the yearly cash flows if the benchmark is 6.5% or 8%, and what does the company give up?
1The situation
Doddabetta Dairy, a mid-sized dairy processor, has borrowed Rs 200 crore for three years from a lender at a floating benchmark rate plus 2%, reset and paid yearly. Its margins are thin and its board dislikes not knowing next year's interest bill.
Its relationship bank offers a three-year interest rate swap on Rs 200 crore: Doddabetta pays a fixed 7.1% and receives the same benchmark, with the same reset and payment dates as the loan. You are on the bank's financing team and are asked to show the client the numbers and what the swap costs it in the scenarios that matter.
2Your task
What fixed rate does the company lock in, what does it pay each year at a 6.5% or 8% benchmark, and what is it giving up?
Quick check
With the swap on, what does Doddabetta pay in a year when the benchmark is 8%?
Worked solution
Try it on paper, then open one step at a time.
30-second answerThe answer to give first
Doddabetta locks in 9.1% a year, Rs 18.2 crore, whatever the benchmark does. At 6.5% the loan costs Rs 17.0 crore and the swap costs Rs 1.2 crore more; at 8% the loan costs Rs 20.0 crore and the swap pays back Rs 1.8 crore. The company gives up the saving if rates fall, about Rs 1.2 crore a year at 6.5%, and takes on a swap it must unwind at market value if it repays early.
Step 1How does the swap turn a floating loan into a fixed one?
Think of a tenant whose rent is linked to an index that moves every year. A friend agrees to pay the index part of the rent each year in return for a fixed sum from the tenant. The tenant now pays a fixed amount, whatever the index does. Under the swap Doddabetta receives the benchmark from the bank and pays it on to the lender, so the two floating flows cancel, and what is left is the loan's 2% credit spreadThe extra interest a borrower pays above the benchmark rate because of its own credit risk. plus the swap's 7.1%: 9.1% fixed. On Rs 200 crore that is Rs 18.2 crore a year.
Step 2What are the cash flows in the two scenarios?
At a 6.5% benchmark the loan costs 8.5%, Rs 17.0 crore. The swap charges 7.1% and pays 6.5%, so Doddabetta pays the bank a net 0.6%, Rs 1.2 crore. Total Rs 18.2 crore. At 8% the loan costs 10%, Rs 20.0 crore, and the bank pays Doddabetta a net 0.9%, Rs 1.8 crore. Total again Rs 18.2 crore. The swap's net payment moves exactly opposite to the loan's interest, which is why the total does not move.
| Benchmark | Loan interest, Rs crore | Swap net, Rs crore | Total with swap | Without swap |
|---|---|---|---|---|
| 6.5% | 17.0 | +1.2 | 18.2 | 17.0 |
| 8.0% | 20.0 | -1.8 | 18.2 | 20.0 |
Step 3What does the company give up, and what does the bank take on?
Three things for the company. If the benchmark falls to 6.5% and stays there, it pays Rs 1.2 crore a year more than it would have unhedged, about Rs 3.6 crore over three years; that is the price of certainty. If it repays the loan early, the swap does not disappear: it must be closed at market value, which costs money if rates have fallen. And the swap only works if its dates and benchmark match the loan's exactly; any mismatch leaves a small floating exposure the board thinks it has removed.
For the bank, this is lending to a middle-market corporate with a second exposure attached. If rates fall by one percentage point soon after the trade, the swap is worth about 1% times Rs 200 crore times a three-year annuity of 2.62, roughly Rs 5.2 crore, owed by the company to the bank. That sits on the same credit line as the loan, so a credit team sizes the line for both. The limit of the analysis is that it assumes the benchmark is the only thing that moves; in practice the company's credit spread on any new borrowing can move too, and the swap does nothing about that.
Where candidates lose it
The common loss is quoting 7.1% as the company's new cost. The swap swaps only the benchmark; the 2% credit spread on the loan is still paid, so the all-in fixed cost is 9.1%.
The second is calling the swap a saving when rates rise and a loss when they fall. The point of the trade is that the total stays at 9.1% either way; judging it after the fact misses why the board wanted it.
What the interviewer asks next
- The company wants to hedge only half the loan. What is its cost at a 6.5% and an 8% benchmark?
- How would an interest rate cap compare with the swap for this client?
- Why might the bank quote a slightly higher fixed rate to this client than to a large corporate?
Asked at Deutsche Bank, Sales and Trading, New York, 2024 (Wall Street Oasis): The case study was relatively simple, focused on lending to a middle-market corporate.
Company names and figures are illustrative.