Interest Rate Swaps

• Protects against adverse movements in interest rates
• Protects borrowing costs or investment yields, in sterling or foreign currency
• No premium is paid to enter into a swap
• Offers versatility as it is totally independent from the actual borrowing or investment
• No principal amount changes hands

An interest rate swap is an instrument for swapping the rate of interest you pay on a loan or receive on a deposit for example from a floating rate of interest to a fixed rate - in an agreed amount, for a specified period of time. Based on interbank interest rates, swaps are available in Singapore dollar and foreign currency.

Companies borrowing at a margin over a floating rate of interest will have to meet increased costs if interest rates rise. The impact of such a rise may mean that a profitable project becomes loss making.

This risk can be overcome by locking into fixed rates in two ways:

• By borrowing at a fixed rate of interest. This alternative has certain limitations, which we discuss below
• By borrowing at a margin over a floating rate of interest and swapping into a fixed rate by way of an interest rate swap

You specify to us the details:

• the amount and currency involved
• the starting date and period of the swap
• whether you want to pay a fixed rate to us and receive a floating rate or vice-versa
• the method of calculating the interest rates to be paid/received under the swap (for example, whether the fixed rate is to be calculated on a quarterly, six monthly or annual basis or whether the floating rate is to be calculated on a one, three or six month SOR (Swap Offer Rate) basis)

We will then advise you of the actual rate we are prepared to pay or receive under the swap.

Your company borrows S$ 10,000,000 for five years at a margin of 3% over three month SOR to fund a factory purchase. Every three months, the loan will need to be rolled over, and the risk to your company is that SOR will be at a higher rate than your budget rate, for part or all of the five year loan period. Your company decides to fix the rate by using a swap. We quote to you a swap rate of 7.50%, and agree to pay you 3m SOR. The swap covers only the SOR linked element of your borrowing costs.

You do not need to be borrowing from HSBC to enter into a swap with us.

Once you have entered into this arrangement, irrespective of market interest rate movements over the specified period, you will continue to pay a fixed rate for your debt of, in our example, 10.50% (7.50% plus the 3% margin).

This example looked at swapping a floating rate commitment for a fixed rate commitment. Alternatively, swaps can also be used by investors to protect against a fall in interest income. A company with a cash surplus, earning a floating rate yield, may be concerned that a fall in rates will have a significant impact on its P&L. It could lock into fixed rates by entering a swap.

The principal amount of the swap does not change hands. Settlement under the swap is made on a net basis. If three month SOR is higher than 7.50% on roll-over, we will pay you the difference. Compensation is paid at the end of the three month roll-over period. If three month SOR is below the swap rate on roll-over, you will compensate us for the difference, again at the end of the three month period. The effect is to maintain your borrowing rate at 10.50% (the agreed swap rate of 7.50% plus the 3% margin).

To calculate any settlement amount, an independently calculated average of three month Singapore dollar SOR rates, gathered from a number of leading banks is used.

The difference between a swap and a fixed rate loan is the versatility offered by the swap. A swap can be tailored to your particular requirements. In our example overleaf, you may have a strong view that interest rates will rise for the next three years, but fall thereafter. You could therefore enter into a swap only for an initial three years. Additionally, you may prefer to hedge only part of your exposure to interest rates and cover only part of your borrowing. The swap does not need to match the underlying transaction. Swaps are also generally easier to unwind than fixed rate loans. There is always a cost if you wish to unwind fixed rate borrowing and re-hedge at lower current rates, but that cost will usually be lower with a swap than a fixed-rate loan.

• A swap is a method of protecting a company against adverse movements in interest rates
• A swap can be used to protect borrowing costs or investment yields, in sterling or foreign currency
• No premium is paid to enter into a swap
• A swap offers versatility as it is totally independent from the actual borrowing or investment
• No principal amount changes hands
• A swap is generally based upon SOR