A:

An interest rate swap involves the exchange of cash flows between two parties based on interest payments for a particular principal amount. However, in an interest rate swap, the principal amount is not actually exchanged. In an interest rate swap, the principal amount is the same for both sides of the currency and a fixed payment is frequently exchanged for a floating payment that is linked to an interest rate, which is usually LIBOR.

A currency swap involves the exchange of both the principal and the interest rate in one currency for the same in another currency. The exchange of principal is done at market rates and is usually the same for both the inception and maturity of the contract.

I

n general, both interest rate and currency swaps have the same benefits for a company. Essentially, these derivatives help to limit or manage exposure to fluctuations in interest rates or to acquire a lower interest rate than a company would otherwise be able to obtain. Swaps are often used because a domestic firm can usually receive better rates than a foreign firm.

For example, suppose company A is located in the U.S. and company B is located in England. Company A needs to take out a loan denominated in British pounds and company B needs to take out a loan denominated in U.S. dollars. These two companies can engage in a swap in order to take advantage of the fact that each company has better rates in its respective country. These two companies could receive interest rate savings by combining the privileged access they have in their own markets.

Swaps also help companies hedge against interest rate exposure by reducing the uncertainty of future cash flows. Swapping allows companies to revise their debt conditions to take advantage of current or expected future market conditions. As a result of these advantages, currency and interest rate swaps are used as financial tools to lower the amount needed to service a debt.

Currency and interest rate swaps allow companies to take advantage of the global markets more efficiently by bringing together two parties that have an advantage in different markets. Although there is some risk associated with the possibility that the other party will fail to meet its obligations, the benefits that a company receives from participating in a swap far outweigh the costs.

For further reading, see Corporate Use Of Derivatives For Hedging and How does the foreign-exchange market trade 24 hours a day?

RELATED FAQS
  1. Can individual investors profit from interest rate swaps?

    Find out how individual investors can speculate on interest rate movements through interest rate swaps by trading fixed rate ... Read Answer >>
  2. What are some risks a company takes when entering a currency swap?

    Read about the risks associated with performing a currency swap, including counterparty credit risk in the event that one ... Read Answer >>
  3. How can a company hedge with currency swaps?

    Read a brief overview of how currency swap exchanges function, why a swap bank is necessary, and how the parties involved ... Read Answer >>
  4. What are the benefits of engaging in a currency swap?

    Read about the benefits of engaging in a currency swap, such as when companies in different countries want to borrow funds ... Read Answer >>
  5. What is an absolute rate?

    An absolute rate is easy to understand once you know the basics of an interest rate swap. An absolute rate is the fixed rate ... Read Answer >>
  6. What are interest rate swaps on the OTC market?

    Learn about interest rate swaps and how they are traded over the counter, and understand the impact of Dodd-Frank on swaps ... Read Answer >>
Related Articles
  1. Trading

    An Introduction To Swaps

    Learn how these derivatives work and how companies can benefit from them.
  2. Trading

    How Are Interest Rate Swaps Valued?

    When trading in financial markets, higher returns are generally associated with higher risk. Hedge your risk with interest rate swaps.
  3. Investing

    What's an Interest Rate Swap?

    An interest rate swap is an exchange of future interest receipts. Essentially, one stream of future interest payments is exchanged for another, based on a specified principal amount.
  4. Managing Wealth

    An In-Depth Look At The Swap Market

    The swap market plays an important role in the global financial marketplace; find out what you need to know about it.
  5. Trading

    Currency Swap Basics

    Find out what makes currency swaps unique and slightly more complicated than other types of swaps.
  6. Trading

    Different Types of Swaps

    Investopedia explores the most common types of swap contracts.
  7. Investing

    How To Read Interest Rate Swap Quotes

    Puzzled by interest rate swap quotes terminology? Investopedia explains how to read the interest rate swap quotes
  8. Trading

    Hedging With Currency Swaps

    The wrong currency movement can crush positive portfolio returns. Find out how to hedge against it.
  9. Trading

    Interest Rate Swaps Explained

    Plain interest rate swaps that enable the parties involved to exchange fixed and floating cash flows.
  10. Investing

    The Advantages Of Bond Swapping

    This technique can add diversity to your portfolio and lower your taxes. Find out how.
RELATED TERMS
  1. Cross-Currency Swap

    An agreement between two parties to exchange interest payments ...
  2. Swap

    A derivative contract through which two parties exchange financial ...
  3. Currency Swap

    A swap that involves the exchange of principal and interest in ...
  4. Foreign Currency Swap

    An agreement to make a currency exchange between two foreign ...
  5. Swap Rate

    The rate of the fixed portion of a swap as determined by its ...
  6. Delayed Rate Setting Swap

    An exchange of cash flows, one of which is based on a fixed interest ...
Hot Definitions
  1. Cover Letter

    A written document submitted with a job application explaining the applicant's credentials and interest in the open position. ...
  2. 403(b) Plan

    A retirement plan for certain employees of public schools, tax-exempt organizations and certain ministers. Generally, retirement ...
  3. Master Of Business Administration - MBA

    A graduate degree achieved at a university or college that provides theoretical and practical training to help graduates ...
  4. Liquidity Event

    An event that allows initial investors in a company to cash out some or all of their ownership shares and is considered an ...
  5. Job Market

    A market in which employers search for employees and employees search for jobs. The job market is not a physical place as ...
  6. Yuppie

    Yuppie is a slang term denoting the market segment of young urban professionals. A yuppie is often characterized by youth, ...
Trading Center