Interest Rate Swap

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DEFINITION of 'Interest Rate Swap'

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.

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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.

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