What is a Liability Swap?
A liability swap is a derivative contract through which two parties exchange their interest rate or currency exposure to a liability. Most swaps involve cash flows based on a notional principal amount.
Usually, the principal does not change hands. One cash flow is fixed, while the other is variable, that is, based on a benchmark interest rate, floating currency exchange rate, or index price.
The terms and structure of a liability swap are the same as they are for an asset swap. With a liability swap exposures to a liability are being exchanged, while an asset swap exchanges exposure to an asset.
Swaps do not trade on exchanges, and retail investors usually do not engage in swaps. Instead, swaps are over-the-counter contracts between businesses or financial institutions.
- A liability is like an asset swap, except with a liability swap the parties are exchanging exposure to liabilities instead of assets.
- Liability swaps can be interest rate related, exchanging a fixed rate for a floating rate (or vice versa), or currency exchange rate related.
- Liabilities swaps are used by institutions to hedge, possibly speculate (rare), or change the rate structure (fixed or floating) of liability and thus better matchup liabilities with the rate structure of assets and other cash flows.
Understanding the Liability Swap
Liability swaps are used to exchange a fixed (or floating rate) debt into a floating (or fixed) debt. The two parties involved are exchanging cash outflows.
For example, a bank may swap a 3% debt obligation in exchange for a floating rate obligation of LIBOR plus 0.5%. Libor may currently be 2.5%, so the fixed and floating rates are the same right now. Over time, though, the floating rate may change. If LIBOR increases to 3%, now the floating rate on the swap is 3.5%, and the party that locked in the floating rate is now paying more for that liability. If LIBOR moves the other way, they will be paying less than they were originally (3%).
Business and institutions use liability swaps to alter whether the rate they pay on liabilities is floating or fixed. They may wish to do this if they believe interest rates will change and they want to potentially benefit from that. They may also enter a liability swap so that the nature of the liability (fixed or floating) matches up with their assets, which may produce fixed or floating cash flows. Swaps can also be used to hedge.
Example of a Liable Swap
As an example, Company XYZ swaps a six-month LIBOR interest rate plus 2.5% liability for ABC's six-month fixed rate 5% liability. The notional principal amount is $10 million.
Company XYZ now has a fixed liability rate of 5%, while Company ABC is taking on the LIBOR plus 2.5% liability. Assume the six-month LIBOR rate is currently 2.5%, so the floating rate is also 5% currently.
Assume that after three months, LIBOR has increased to 2.75%, so the floating rate is now 5.25%. Company ABC is now worse off than they were before because they are paying a higher floating rate than the fixed rate they originally had. That said, companies don't typically enter swaps to make or lose money, but rather to exchange rates based on their business needs.
If LIBOR drops to 2.25%, the floating rate is now 4.75%, and Company ABC is paying a lower rate than the 5% they originally were.
Since principal amounts are not typically exchanged, and the liabilities don't actually change hands, changes in the interest rate over time are dealt with by making settlements at regular intervals or when the swap expires. Since the parties set the terms of the swap, they create terms to which both parties agree.