Interest Rate Swap

Interest rate swap

A binding agreement between counterparties to exchange periodic interest payments on some predetermined dollar principal, which is called the notional principal amount. For example, one party will pay fixed and receive variable.

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interest rate swap

See swap.

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Interest Rate Swap

The exchange of interest rates for the mutual benefit of the exchangers. The exchangers take advantage of interest rates that are only available, for whatever reason, to the other exchanger by swapping them. The two legs of the swap are a fixed interest rate, say 3.5%, and a floating interest rate, say LIBOR + 0.5%. In such a swap, the only things traded are the two interest rates, which are calculated over a notional value. Each party pays the other at set intervals over the life of the swap. For example, one party may agree to pay the other a 3.5% interest rate calculated over a notional value of $1 million, while the second party may agree to pay LIBOR + 0.5% over the same notional value. It is important to note that the notional amount is arbitrary and is not actually traded. This is also called a plain vanilla swap.

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Interest Rate Swap

What Does Interest Rate Swap Mean?

An agreement between two parties (known as counterparties) in which one stream of future interest payments is exchanged for another stream, based on a specified principal amount. Interest rate swaps often involve exchanging a fixed payment for a floating payment, which is linked to an interest rate (most often the LIBOR). A company typically uses interest rate swaps to limit or manage its exposure to fluctuations in interest rates or to obtain a marginally lower interest rate than it would have been able to get without the swap.

Investopedia explains Interest Rate Swap

Interest rate swaps are the exchange of one set of cash flows (based on interest rate specifications) for another. Because they trade over the counter (OTC), they are really contracts set up between two or more parties and thus can be customized in a number of ways. Generally, swaps are sought by firms that desire a type of interest rate structure that another firm can provide less expensively. For example, let's say Cory's Tequila Company (CTC) is seeking to lend funds at a fixed interest rate, but Tom's Sports Inc. (TSI) has access to marginally cheaper fixed-rate funds. Tom's Sports can issue debt to investors at its low fixed rate and then trade the fixed-rate cash flow obligations to CTC for floating-rate obligations issued by TSI. Even though TSI may have a higher floating rate than CTC, by swapping the interest structures it is best able to obtain inexpensively, the combined costs are decreased, a benefit that can be shared by both parties.

Related Terms:
• Bond
• Debt
• Interest Rate
• Notional Value
• Swap