Interest rate swaps are derivative products which help in transforming the cash flows of existing debt issues. These are not only useful in covering the existing exposure but also in the new issue market. For instance, consider a company X willing to raise $20 million by issuing a fixed rate note with semi-annual coupon payments over a 3-year period. The company already has some fixed rate exposure and is not in a position for another exposure. A large institutional investor is willing to accept the credit risk of X on a privately placed loan provided that the deal can be structured as per its terms and conditions. As the fund manager of this investment company anticipates a decline in interest rates, he/she would like to design the loan contract based on his/her perception. Hence he/she links the semi-annual coupon on the note inversely with the level of some variable interest rate index such as LIBOR. As the coupon rate increases when the general level of interest rates decreases and vice versa, this is termed as reverse-floating rate contract. Let us take the following illustration to understand the swap-linked note.
Assume that company X and the investor agree to reset the coupon semi-annually at a level equal to 10% minus LIBOR. If 6-month LIBOR is 6%, then the coupon will be (10% - 6%) = 4%. If LIBOR is 3%, then the coupon will be (10% - 3%) = 7%. Thus the investor gains from falling rates and is subject to less credit risk than what would have been if a regular bond issue had an embedded derivative. A reverse floater will benefit more from a rate decline than that could be obtained from a fixed rate note of identical maturity.