Companies may be hesitant to use interest rate derivatives because they may appear too complex and their benefits may not always be clear at first glance.
In other cases, companies may be using the simplest kinds of swaps when a more sophisticated approach would serve them better or would be more consistent with their outlook on interest rates in general.
Smart Business spoke with Edwin Martinez, managing director in PNC’s Derivative Products Group, about the benefits of various kinds of interest rate derivatives.
What makes interest rate derivatives attractive right now?
Over the past year and a half, we have seen dramatic evidence of the damage that excessive or unmanaged risk can do to both businesses and to the economy. Yet taking on risk is unavoidable if you want to grow your business and improve your bottom line.
The answer to this dilemma is to address and actively manage the risks you can control to maximize the value of your business.
Interest rate derivatives can help you mitigate the risk of unpredictable interest rate swings. By adding certainty around this expense category on your income statement at a time when improving margins is critical, you can ensure that more of each revenue dollar drops to the bottom line.
Interest rate derivatives are often considered difficult to understand. How do they work?
Interest rate derivatives, such as swaps, are contractual agreements between the bank and a client. The parties agree to exchange different forms of interest payments through a stated maturity date. In one of the most popular versions, interest rate swaps effectively convert a floating rate on a loan to a fixed rate.
To visualize how an interest rate swap works, take the situation of the floating rate borrower who feels that rates will rise over the term of a loan, significantly increasing interest costs and potentially eroding already strained operating margins. This client enters into a swap agreement with the bank, whereby the client receives a floating rate, such as LIBOR, that offsets the interest on its underlying loan agreement and pays a fixed rate.
The payment of LIBOR from the bank to the client offsets the client’s LIBOR payment to the lender. After the LIBOR payments cancel each other out, the client is left with an effective all-in fixed rate consisting of the swap rate plus the spread over LIBOR.
