18 March 2014
Interest Rate Swaps Explained
In 2005, high-street banks and financial institutions offered small and medium businesses a way to hedge their risks and began selling highly complex financial products called Interest Rate Swaps.
In many cases, those who were sold the swaps found themselves locked into an expensive, but ultimately useless product. Thousands of small and medium businesses are now entitled to take action against their banks for mis-selling.
If the bank did not do any of the following, then you may have been mis-sold a financial product.
* Make it clear that the swap is separate to the loan facility
* Specify the breakage cost
* Make it clear that there are alternative products that are more suitable
* Explain what happens if the interest rates fall below their current levels
If the bank did do any of the following, then you may have been mis-sold a financial product.
* Over-hedged your swap (where the amounts and/or duration of the swap did not match the underlying loans)
* Provided complex and misleading presentations or emails explaining the nature of the swaps
An interest rate swap is an agreement between two parties where one type of interest payment (such as a fixed interest rate) is swapped for another (floating rate) for a certain period of time.
If interest rates fall, a party receiving a fixed-rate payment receives profits and loses if interest rates rise. On the other hand, the payer who is paying a fixed-rate payment profits if rates rise and loses if rates fall.
You will need to pay a significant break cost if you want to terminate the swap during its lifetime.
An interest rate cap sets an upper limit (cap strike rate) on the interest rate rise and provides you with the known maximum interest rate. A cap allows you to pay a non-refundable premium, which can be spread out over the life of a cap, to ensure against interest rates going up.
When the interest rate rises above the cap strike rate, the bank will reimburse you the extra interest. And when the interest rate goes down, you pay a lower rate of interest on your borrowing.
If the loan is repaid early, you can either let the cap run to maturity or may cancel it; which means you don’t have to pay the breakage cost (exit fee).
An interest rate collar is a combination of an interest rate cap (highest interest rate) and interest rate floor (lowest interest rate).
A collar allows you to sell a floor to the cap provider. Once the floor is sold, you get a premium which is netted off against the cap’s premium.
If the interest rates increase beyond the cap strike level, the bank will pay you, but you need to pay a premium for purchasing a cap.
The interest rates may decrease beyond the cap strike level. If this happens, you pay the bank and receive a premium for selling the floor to the bank. You will need to pay a significant break cost if the collar needs to be terminated early.
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