Interest Rate Swap

Loading the player...

What is an 'Interest Rate Swap'

An interest rate swap is an agreement between two parties (known as counterparties) where one stream of future interest payments is exchanged for another based on a specified principal amount. Interest rate swaps often exchange a fixed payment for a floating payment that is linked to an interest rate (most often the LIBOR). A company will typically use interest rate swaps to limit or manage 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.

BREAKING DOWN 'Interest Rate Swap'

Interest rate swaps are simply the exchange of one set of cash flows (based on interest rate specifications) for another. Because they trade OTC, they are really just contracts set up between two or more parties, and thus can be customized in any number of ways.

Generally speaking, 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 loan 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 they are best able to obtain, their combined costs are decreased - a benefit that can be shared by both parties.

RELATED TERMS
  1. Swap Rate

    The rate of the fixed portion of a swap as determined by its ...
  2. Swap

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

    An exchange of debt related interest rates between two parties ...
  4. Asset Swap

    Similar in structure to a plain vanilla swap, the key difference ...
  5. Fixed-For-Floating Swap

    An advantageous arrangement between two parties (counterparties), ...
  6. Cross-Currency Swap

    An agreement between two parties to exchange interest payments ...
Related Articles
  1. Markets

    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.
  2. Investing

    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. Trading

    An Introduction To Swaps

    Learn how these derivatives work and how companies can benefit from them.
  4. Investing

    Interest Rate Swaps Explained

    Plain interest rate swaps that enable the parties involved to exchange fixed and floating cash flows.
  5. Managing Wealth

    How To Read Interest Rate Swap Quotes

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

    Hedging With Currency Swaps

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

    The Fast-Paced World of Libor & Fixed Income Arbitrage

    LIBOR is an essential part of implementing the swap spread arbitrage strategy for fixed income arbitrage. Here is a step-by-step explanation of how it works.
  8. Managing Wealth

    The Advantages Of Bond Swapping

    This technique can add diversity to your portfolio and lower your taxes. Find out how.
  9. Investing

    Introduction To Counterparty Risk

    Unlike a funded loan, the exposure from a credit derivative is complicated. Find out everything you need to know about counterparty risk.
  10. Trading

    Effects of OIS Discounting for Derivative Traders

    The use of OIS discounting has important implications for derivative valuations and could positively or negatively impact a trader's profit or loss.
RELATED FAQS
  1. Do interest rate swaps trade on the open market?

    Learn how interest rate swaps are traded on the OTC and interbank markets, and how these swaps can be used to arbitrage different ... Read Answer >>
  2. Can bond traders trade on interest rate swaps?

    Read about interest rate swaps and why these transactions are performed by institutional actors in the bond market, not individual ... Read Answer >>
  3. What would motivate an entity to enter into a swap agreement?

    Learn why parties enter into swap agreements to hedge their risks, and understand how the different legs of a swap agreement ... Read Answer >>
  4. What is the difference between derivatives and swaps?

    Find out more about derivative securities, swaps, examples of derivatives and swaps, and the main difference between derivative ... Read Answer >>
  5. How did the LIBOR scandal affect interest rate swaps?

    Find out how the LIBOR scandal directly enriched some interest rate swap traders and harmed others by understating the real ... Read Answer >>
  6. 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 >>
Hot Definitions
  1. Sell-Off

    The rapid selling of securities, such as stocks, bonds and commodities. The increase in supply leads to a decline in the ...
  2. Brazil, Russia, India And China - BRIC

    An acronym for the economies of Brazil, Russia, India and China combined. It has been speculated that by 2050 these four ...
  3. Brexit

    The Brexit, an abbreviation of "British exit" that mirrors the term Grexit, refers to the possibility of Britain's withdrawal ...
  4. Underweight

    1. A situation where a portfolio does not hold a sufficient amount of a particular security when compared to the security's ...
  5. Russell 3000 Index

    A market capitalization weighted equity index maintained by the Russell Investment Group that seeks to be a benchmark of ...
  6. Enterprise Value (EV)

    A measure of a company's value, often used as an alternative to straightforward market capitalization. Enterprise value is ...
Trading Center