An amortizing swap is a type of interest rate swap where the notional principal amount decreases over time. This means that the interest payments on both the fixed and floating rates are based on a smaller principal amount as the swap matures. An amortizing swap is often used by borrowers who have a loan with a fixed interest rate and want to hedge against the risk of interest rate changes. By entering into an amortizing swap, the borrower can effectively convert their fixed-rate loan into a floating-rate loan, while also reducing their exposure to the swap as they pay off their loan.
An example of an amortizing swap is as follows:
- Party A borrows $100 million from a bank at a fixed interest rate of 5% for 10 years, with annual payments.
- Party A enters into an amortizing swap with Party B, where Party A pays a floating rate of LIBOR + 1% and receives a fixed rate of 4.5% on a notional principal amount that starts at $100 million and declines by $10 million every year.
- In the first year, Party A pays the bank $5 million (5% of $100 million) and pays Party B $2 million (LIBOR + 1% of $100 million). Party A receives $4.5 million (4.5% of $100 million) from Party B. The net cash flow for Party A is -$2.5 million ($4.5 million – $5 million – $2 million).
- In the second year, Party A pays the bank $5 million (5% of $100 million) and pays Party B $1.8 million (LIBOR + 1% of $90 million). Party A receives $4.05 million (4.5% of $90 million) from Party B. The net cash flow for Party A is -$2.75 million ($4.05 million – $5 million – $1.8 million).
- This process continues until the tenth year, when Party A pays the bank $5 million (5% of $100 million) and pays Party B $0.2 million (LIBOR + 1% of $10 million). Party A receives $0.45 million (4.5% of $10 million) from Party B. The net cash flow for Party A is -$4.75 million ($0.45 million – $5 million – $0.2 million).
By using an amortizing swap, Party A has effectively lowered their fixed interest rate from 5% to 4.5%, while also reducing their exposure to the swap as they repay their loan. Party B, on the other hand, has agreed to receive a lower fixed rate than the market rate, but also benefits from the declining notional principal amount, which reduces their credit risk and capital requirements.
Basic Theory
An amortising swap is a type of interest rate swap where the notional principal decreases over time. Unlike a traditional interest rate swap with a constant notional amount, in an amortising swap, the notional amount is gradually reduced, typically in equal installments. This structure allows for more flexibility in managing cash flows and can be beneficial for entities with changing financial obligations.
Procedures
- Determine the Terms of the Swap: Define the notional amount, fixed and floating interest rates, payment frequency, and the amortisation schedule.
- Create the Amortisation Schedule: Develop a table outlining the notional principal, interest payments, and amortisation for each period.
- Calculate Cash Flows: Use Excel formulas to determine the fixed and floating cash flows for each period based on the interest rates and notional amounts specified in the swap agreement.
- Implement the Swap Formulas: Set up formulas in Excel to calculate the net cash flow exchanged between the two parties in the amortising swap.
- Evaluate Hedge Effectiveness: Assess the effectiveness of the amortising swap in managing interest rate risk by comparing cash flows with and without the swap.
Scenario
Let’s consider a scenario where Company A has entered into an amortising swap with Company B. The notional principal is $1,000,000, the fixed interest rate is 4%, and the floating rate (LIBOR) is currently 3%. The swap has a term of 5 years, and the notional principal is amortised equally over each year.
Amortisation Schedule
| Year | Notional Principal | Fixed Rate (%) | Floating Rate (%) | Fixed Cash Flow | Floating Cash Flow | Amortisation | Net Cash Flow |
|---|---|---|---|---|---|---|---|
| 1 | $1,000,000 | 4 | 3 + Spread | =C2*$B$2 | =C2*(D2-$B$2) | =($A$2/5) | =E2+F2 |
| 2 | $800,000 | 4 | 3 + Spread | =C3*$B$2 | =C3*(D3-$B$2) | =($A$2/5) | =E3+F3 |
| 3 | $600,000 | 4 | 3 + Spread | =C4*$B$2 | =C4*(D4-$B$2) | =($A$2/5) | =E4+F4 |
| 4 | $400,000 | 4 | 3 + Spread | =C5*$B$2 | =C5*(D5-$B$2) | =($A$2/5) | =E5+F5 |
| 5 | $200,000 | 4 | 3 + Spread | =C6*$B$2 | =C6*(D6-$B$2) | =($A$2/5) | =E6+F6 |
Calculation in Excel
Assuming the fixed rate is in cell B2, the floating rate in cell D2, and the notional principal in cell A2, you can use the following formulas:
- For Fixed Cash Flow (in cell E2):
=C2*$B$2 - For Floating Cash Flow (in cell F2):
=C2*(D2-$B$2) - For Amortisation (in cell G2):
=($A$2/5) - For Net Cash Flow (in cell H2):
=E2+F2
Drag these formulas down to fill the respective cells for each period.
Results
The table and calculations provide a clear picture of the cash flows over the 5-year period for both fixed and floating rates, amortisation, and the net cash flow exchanged between the parties.
Other Approaches
While the scenario above assumes equal amortisation, other approaches exist. For instance, front-loaded or back-loaded amortisation schedules can be implemented based on the specific needs of the parties involved. Additionally, variable amortisation schedules, where the notional principal decreases by varying amounts each period, offer further customization.
