Companies use interest rate swaps to manage borrowing when choosing between fixed interest rates and floating interest rates. According to Investopedia, an interest rate swap is a contract or agreement in which one party exchanges its fixed stream of payments for someone else's floating payments, or vice-versa. The purpose of the swap is to hedge potential mismanagement of any future debt repayment when a company's original debt is not suitable for its operations. But, sometimes companies may find it difficult to swap two loans, unable to perfectly pair up all the loan elements such as the amount of principal, payment frequency and loan maturity. So, one way to measure hedge effectiveness is to use the critical term match method, says KPFD, a company specializing in financial risk management.
Measure the principals of the two loans. If the principals of the two loans are not perfectly matched, the hedge effectiveness is not perfect either. Sometimes companies may swap a $100,000 floating-rate loan for a $90,000 fixed-rate loan if that is the closest match available. The unhedged $10,000 part of the floating-rate loan may or may not be effectively managed, with only a fixed stream of cash inflow from operations.
Compare the frequencies of the periodic repayments of the loans. Some loans may require monthly payments while others stipulate quarterly terms. When a swapped loan has a schedule that demands more frequent payments than the one the company initially takes out, the original loan is not perfectly hedged. Whether the company can manage to meet those extra payment depends on its cash-inflow.
Check the maturity date of each loan. Mismatched maturities can affect the hedge effectiveness of an interest swap. The larger the difference between the maturities of the two loans, the less effective the interest rate swap is. For example, to avoid making uneven periodic payments when swapping a floating-rate loan for a fixed-rate, a company may end up continuing paying beyond its original loan term. Companies must weigh the benefits and costs of a hedge.