Virtually every financial entity has exposure to interest rates. And interest rate swaps provide a direct mechanism to manage this exposure, allowing entities to hedge against unfavorable movements in interest rates that could impact their costs or returns. Let's have a look at how this could work in practice by using the following scenario. Picture a European corporation that has ventured into the financial markets with a significant borrowing a 100 million Euro floating rate loan over a five year term.

The cost of this borrowing is linked to the six month EURIBOR or adjusted every six months with an additional constant charge or spread of 2.5%. The company's treasurer vigilant of the economic climate, foresees potential surges in the EURIBOR rates within the loan's lifespan. Such a scenario could increase the company's financial burden. An outcome the treasurer is keen to avoid. The aim here is to establish a hedge against the potential rising tide of interest rates. In response, the company might look to use interest rate swaps as a potential hedging instrument. A market maker has quoted a bid of 2.687% and an ask of 2.727% for a 100 million Euro five year swap against six month EURIBOR. In order to hedge the risk of rising Euro ball rates. Should our corporate treasurer elect pay or receive the swap rate in this swap, and which of the two rates apply the bid or the offer? To fully grasp the strategic choices at play, we must first identify the primary risk. The corporate faces, they are currently subject to a variable interest rate on their loan linked to the six month EURIBOR plus a 2.5% margin. The concern is a potential rise in EURIBOR, which would naturally inflate their interest payments. To mitigate this risk, the corporation can engage in an interest rate swap, effectively transforming their floating rate loan into a fixed rate loan From a cashflow perspective.

The mechanism is relatively straightforward. The corporation enters into a payer swap, committing to pay a fixed rate of interest over a five year period while receiving six month EURIBOR In return. Should EURIBOR increase so to will the payments they receive from the swaps floating leg, offsetting the hike and interest payments on the loan.

Now, which swap rate would apply? In this case, the market maker has presented two rates, 2.687%, and 2.727% known respectively as the bid and ask. These rates represent the thresholds at which the market maker is prepared to transact the swap. The bid asks spread, the difference between these two numbers is the market maker's remuneration for providing liquidity and the flexibility for clients to act either as the payer or receiver in the swap.

For our corporate treasurer, the less favorable rate from their perspective, the ask rate applies. Hence, they would engage in the swap at a rate of 2.727%. Exchanging this for the six month EURIBOR.

Considering the combined position, the corporation will continue to pay the loans floating rate of six month EURIBOR plus 2.5 percent, but will concurrently receive six month EURIBOR through the swap, resulting in these two floating amounts for the six month EURIBOR offsetting each other. To secure this arrangement, they will pay out a fixed rate of 2.72% to the swap counterparty.

Ultimately, this creates a synthetic fixed rate for the corporationm irrespective of where six month EURIBOR fluctuates over the following five years. The corporation's net interest payment on the borrowed sum will be approximately 5.227%, which is the sum of the fixed swap rate of 2.727%, and the loan's margin of 2.5%.