Next video:
Loading the player...

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.

Each participant in the swap is referred to as a party, or together, as counterparties.

Financial institutions use interest rate swaps to manage credit risk, hedge potential losses, and earn income through speculation.  While interest swaps are very complex, they allow financial institutions and corporations to manage debt and risk more effectively.

The most common type of interest rate swap is the vanilla swap.  In a vanilla swap, one party – the payer – agrees to pay a fixed-rate interest, while the other party – the receiver -- agrees to pay floating-rate interest, which is usually tied to the London Inter-bank Offered Rate (LIBOR).  Note that the counterparties do not swap their actual investments, or their entire interest payments. They simply agree to make payments to one another based on the rise or fall of the floating interest rate. 

There are potential benefits and risks for both parties in an interest rate swap. If interest rates rise, the payer benefits, because their fixed rate is unchanged, and the receiver now owes them the difference between the fixed rate and the floating rate. If interest rates drop, the receiver wins, because their floating rate is now lower than the fixed rate, and they will be receiving the difference from the payer.

Related Articles
  1. 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.
  2. 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.
  3. 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
  4. Trading

    Interest Rate Swaps Explained

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

    CFTC Probes Banks' Use of Interest Rate Swaps

    U.S. regulators are probing banks' trading and clearing of interest rate swaps, which played a central role in the 2008 financial crisis
  6. Investing

    Understanding Total Return Swaps

    A total return swap is a contract in which a payer and receiver exchange the credit risk and market risk of an underlying asset.
  7. Managing Wealth

    Managing Interest Rate Risk

    You need certain tools to manage the risk that comes with changing rates.
  8. Investing

    PIMCO’s Mutual Fund for Investment Grade Bonds (PTTRX)

    Explore the complicated and often arcane makeup of the PIMCO Total Return Fund, and identify the fund's management style and top five holdings.
  9. Trading

    Derivatives 101

    A derivative investment is one in which the investor does not own the underlying asset, but instead bets on the asset’s price movement with another party.
  10. Investing

    Harvard Gets a Failing Grade on Interest-Rate Swaps

    Harvard is among scores of colleges and universities spaying the price for investing in interest-rate swaps that imploded during the financial crisis.
Hot Definitions
  1. Payback Period

    The length of time required to recover the cost of an investment. The payback period of a given investment or project is ...
  2. Collateral Value

    The estimated fair market value of an asset that is being used as loan collateral. Collateral value is determined by appraisal ...
  3. Fiduciary

    A fiduciary is a person who acts on behalf of another person, or persons to manage assets.
  4. Current Account

    The difference between a nation’s savings and its investment. The current account is defined as the sum of goods and services ...
  5. Liability

    Liabilities are defined as a company's legal debts or obligations that arise during the course of business operations.
  6. Quick Ratio

    The quick ratio is an indicator of a company’s short-term liquidity. The quick ratio measures a company’s ability to meet ...
Trading Center