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The primary way they achieve this is through interest rate swaps.
Here’s how it works:
Interest Rate Swaps:
* An interest rate swap is an agreement between two parties to exchange one stream of future interest payments for another, based on a specified principal amount.
* The most common type involves swapping fixed-rate interest payments for floating-rate interest payments, or vice versa.
How Companies Use Swaps to Reduce Borrowing Costs:
* Converting Floating-Rate Debt to Fixed-Rate Debt at a Potentially Lower Cost:
* A company might find it can borrow at a lower initial interest rate with a floating-rate loan compared to a fixed-rate loan.
* However, they might prefer the stability of fixed payments to manage their cash flow and protect against potential interest rate increases.
* By entering into an interest rate swap, they can agree to pay a fixed interest rate to a counterparty in exchange for receiving floating-rate payments that match their loan’s interest payments.
* The fixed rate they end up paying through the swap can sometimes be lower than the fixed rate they could have obtained directly on a fixed-rate loan. This potential saving arises from various market factors and the creditworthiness of the parties involved.
* Converting Fixed-Rate Debt to Floating-Rate Debt to Potentially Benefit from Lower Rates:
* Conversely, a company with existing fixed-rate debt might want to take advantage of an environment where interest rates are expected to fall.
* They can enter into a swap to receive fixed-rate payments (matching their debt payments) and pay floating-rate payments.
* If interest rates do decline, their actual borrowing cost effectively decreases.
Other Ways Derivatives Can Indirectly Reduce Borrowing Costs:
* Reducing Overall Risk: By using other types of derivatives to hedge various risks (like currency risk or commodity price risk), companies can become less volatile and appear less risky to lenders. This can potentially lead to better credit ratings and lower borrowing spreads (the additional interest rate a lender charges above a benchmark rate).
* Enhanced Financial Stability: Effective use of derivatives for hedging can stabilize a company’s cash flows and earnings, making them a more reliable borrower in the eyes of creditors, potentially resulting in lower interest rates on their debt.
Examples:
* A manufacturer with a floating-rate loan might use an interest rate swap to pay a fixed rate, effectively locking in their interest expense and protecting against rate hikes. They might achieve a lower overall fixed cost than if they had initially taken out a fixed-rate loan.
* An exporter receiving revenues in a foreign currency might use currency forwards to lock in exchange rates. This reduces the uncertainty in their future cash flows, making their debt servicing more predictable and potentially leading to better borrowing terms.
Important Considerations:
* Counterparty Risk: When entering into swaps or other OTC derivatives, there is a risk that the other party might default on their obligations.
* Complexity: Derivative contracts can be complex, and it’s crucial for companies to have a thorough understanding of the risks involved.
* Market Fluctuations: While derivatives can help manage risk, they also respond to market fluctuations, and their value can change.
In conclusion, interest rate swaps are a primary tool for companies to directly reduce their borrowing costs by strategically altering the nature of their interest rate obligations. Additionally, using other derivatives to hedge various business risks can indirectly lead to lower borrowing costs by improving a company’s financial stability and creditworthiness.

Video courtesy of Eurex

Video courtesy of Eurex