Fixed Rate Debt

Fixed Rate Debt and Embedded Options considerations in Treasury Management.

Fixed rate debt typically includes either a prepayment option or, in the case of publicly traded debt, a call provision.

In substance this right is no more and no less than a put option on interest rates and a right which becomes more valuable the further interest rates fall. By way of contrast, swap agreements do not contain a prepayment option. The early termination of a swap contract will involve the payment, in some form or other, of the value of the remaining contract period to maturity.

The question arises as to why an interest rate swap can produce apparent financial benefits for both counterparties.

The true explanation is more complicated than can be provided by the concept of comparative advantage alone.

Information asymmetries are a factor, together with the fact that the fixed rate payer in an interest rate swap -- reflecting the fact that he has no early termination right -- is not paying a premium for the implicit interest rate option embedded within a fixed rate loan that does contain a pre-payment rights. This saving is divided between both counterparties to the swap.