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

    An Introduction To Swaps

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

    Different Types of Swaps

    Investopedia explores the most common types of swap contracts.
  4. Trading

    Interest Rate Swaps Explained

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

    Currency Swap Basics

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

    Hedging With Currency Swaps

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

    Managing Interest Rate Risk

    Interest rate risk stems from the possibility that an interest-bearing asset’s value will change due to changing interest rates.
  8. 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
  9. Managing Wealth

    Managing Interest Rate Risk

    Learn which tools you need to manage the risk that comes with changing rates.
  10. Investing

    The Advantages Of Bond Swapping

    This technique can add diversity to your portfolio and lower your taxes. Find out how.
Hot Definitions
  1. Profitability Index

    An index that attempts to identify the relationship between the costs and benefits of a proposed project through the use ...
  2. Restricted Stock Unit

    Compensation offered by an employer to an employee in the form of company stock. The employee does not receive the stock ...
  3. Operating Ratio

    A ratio that shows the efficiency of a company's management by comparing operating expense to net sales. Calculated as:
  4. Expense Ratio

    A measure of what it costs an investment company to operate a mutual fund. An expense ratio is determined through an annual ...
  5. Pro Forma

    A Latin term meaning "for the sake of form". In the investing world, it describes a method of calculating financial results ...
  6. Trumpcare

    The American Health Care Act, also known as Trumpcare and Ryancare, is the Republican proposal to replace Obamacare.
Trading Center