I had read an interesting paper a few years ago about how interest rate swap dealers take advantage of credit pricing anomalies to reduce the cost of borrowing for companies while still making money. I was reminded about it when I met a hedge fund manager over the weekend at a party who made mention of a similar strategy.

**What is an interest rate swap?**

The most basic interest rate swap is when you exchange a series of cash flows based on a floating rate interest payment for a series of cash flows based on a fixed rate interest payment. There are a few reasons you might want to do this. One might be because your company has a change in risk policy and wants to trade the risk of a variable rate interest payment (that could go up suddenly) for a fixed rate that might start out higher, but will stay constant. There are other reasons, but this is just a primer so we’ll leave it at that.

**What is an interest rate swap dealer?**

An interest rate swap dealer can facilitate these types of transactions. Normally you would expect them to find an offsetting transaction so as to reduce their risk. So if they find someone looking to exchange fixed for floating, they might try to find someone else who wants to exchange floating for fixed. They act as the intermediary for both companies.

Now, if the swap dealer has a salesforce, they may be proactively contacting their clients and figuring out ways for them to save money on interest payments. One way they do that is by identifying two different companies with comparative borrowing advantages.

**What is a comparative borrowing advantage?**

If you have one company (let’s call them ABC) that can borrow at 4% fixed and Prime +0.25% for variable and another company (let’s call them XYZ) that can borrow at 4.5% fixed and Prime + 0.5% then we see that ABC has a better credit rating as it gets better rates for fixed and variable. BUT on a comparative basis the differentials show a 0.5% advantage for fixed loans (4% versus 4.5%), but only a 0.25% advantage for variable (Prime +0.25% versus Prime + 0.5%).

Comparatively, ABC is better off borrowing in the fixed rate market. But if they desire a floating rate loan a swap dealer can engineer a discount and still make money.

The swap dealers salesperson will try to identify such scenarios and match the companies up accordingly as follows. They will tell ABC to borrow in the fixed rate and offer them a swap for a floating rate. They will find a company like XYZ and tell them to borrow in the floating rate market and swap with them for a fixed rate payment.

**ABC**

So ABC will borrow at 4% fixed, and enter into a swap with the swap dealer. The swap dealer may offer to make payments to ABC at 3.85% in exchange for floating rate payments of Prime + 0% from ABC. ABC now has a floating rate obligation of Prime + 0% plus the spread on the fixed payments to the lender (4%) less the receipt of fixed rate payments from the swap dealer (3.85%). Therefore the spread is 0.15% and added to Prime that is Prime + 0.15%. So ABC is now borrowing overall at a rate less than it could have secured from the variable rate market (that was Prime + 0.25% remember). So they come out ahead by 0.10%.

**XYZ**

XYZ will borrow at Prime + 0.5%, and enter into a swap with the swap dealer. The swap dealer may offer to make payments to XYZ at Prime + 0% in exchange for fixed rate payments of 3.9% from XYZ. XYZ now has a fixed rate obligation equal to this 3.9% plus the spread on the variable rate payments to the lender (Prime + 0.5%) versus the receipt of variable payments from the swap dealer (Prime + 0%). Since the “Primes” cancel each other out, the spread is 0.5% and added to 3.9% = 4.4%. So XYZ is now borrowing overall at a rate less than it could have secured from the fixed rate market (that was 4.5%). So they come out ahead by 0.10%.

**Swap Dealer**

Remember, the swap dealer is receiving payments from ABC at Prime + 0% and simultaneously they are making payments to XYZ at Prime + 0%. So these cancel out. Further they are making fixed payments to ABC at 3.85% and receiving fixed payments from XYZ at 3.9%. 3.9% – 3.85% = 0.05%. So the swap dealer is ahead by 0.05%.

**Conclusion**

By identifying comparative interest rate differential advantages for borrowers it’s possible for an interest rate swap dealer to make money for itself while saving money for its clients at the same time. ABC was able to save 0.10% versus the variable rate offered to it by the market even though they had to initially borrow from the fixed rate market to do it. XYZ was also able to save 0.10% versus the fixed rate offered to it by the market even though it had to initially borrow from the variable rate market to do it. And the interest rate swap dealer was able to earn 0.05% by facilitating it all without exposing itself to any interest rate risk by finding the two companies with offsetting desires.

If a salesperson finds two companies looking for $100 million to borrow, this translates into an annual $100,000 savings for each company and $50,000 in revenue to the swap dealer. I’m guessing, but the salesperson might get a one time 20% commission for a pay day of $10,000 for a few days of number crunching and a lot of days of prospecting (plus a $100K base probably).

- My Own Advisor[…] Preet Banerjee gave us the low-down about interest rate swaps, interest rate swap dealers and comparative borrowing advantages. […]