DEFINITION of 'Liability Swap'

An exchange of debt related interest rates between two parties - usually large corporations. In a liability swap, two currently identical (in nominal value) cash flows are exchanged. Usually a variable (floating) rate is exchanged for a fixed rate of income. Swaps are undertaken because each company receives a better rate of interest by trading with the other than they would if they chose a more traditional financing route.

BREAKING DOWN 'Liability Swap'

For example, XYZ may swap a six-month LIBOR interest rate for ABC's six-month fixed rate of 5% on a notional principal of $10 million dollars. Due to the split, XYZ will pay a fixed interest payment of 5%, instead of the floating rate.

A swap will have an initial value of zero because the initial cash flows are the same. Over time, however, this will change as interest rates change and the swap will have either a positive or negative value for each contract holder. In certain cases, the swap can be marked-to-market periodically to clear out the unrealized gains and losses by making any payments due.

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