Liability Swap

What Is a Liability Swap?

A liability swap is a financial derivative in which two parties exchange debt-related interest rates (e.g. the yield on a bond), usually a fixed rate for a floating rate, or currency exposure to a liability.

The terms and structure of a liability swap are structurally the same as they are for an asset swap. Except, with a liability swap exposures linked to a liability are being exchanged, while an asset swap exchanges exposure to an asset.

Understanding Liability Swap

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.

Swaps do not trade on exchanges, and retail investors usually do not engage in swaps. Instead, swaps are over-the-counter (OTC) contracts between businesses or financial institutions. 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 the London Interbank Offered Rate (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%).

Principal amounts are not typically exchanged, and so the liabilities don't actually change hands. Therefore, changes in the interest rate over time are dealt with by making netting settlements at regular intervals or when the swap expires. As the counterparties set the terms of the swap, they create terms to which both parties agree.

Why Use Liability Swaps?

Businesses and financial 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.

Liability Swap Example

As an example, Company XYZ swaps a six-month LIBOR interest rate plus 2.5% liability for ABC's six-month fixed rate of 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 it 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.