What is a Fixed-For-Floating Swap
A fixed-for-floating swap is a contractual arrangement between two parties in which one party swaps the interest cash flows of fixed rate loan(s), with those of floating rate loan(s) held by another party. The principal of the underlying loans is not exchanged.
BREAKING DOWN Fixed-For-Floating Swap
There are a few main motivations for a loan holder to execute a fixed-for-floating swap:
- Reduce interest expense by swapping for a floating rate if it is lower than the fixed rate currently being paid;
- Better match assets and liabilities that are sensitive to interest rate movements;
- Diversify risks in a total loan portfolio by exchanging a portion of fixed rate to floating rate; and/or
- Perform a financial hedge with an expectation that market interest rates will decline.
Example of a Fixed-for-Floating Swap
Suppose Company X carries a $100 million loan at a fixed rate of 6.5%. Company X expects that the general direction of interest rates over the near or intermediate term is down. Company Y, carrying a $100 million loan at LIBOR + 3.50% (floating rate loan), has an opposite view; it believes interest rates are on the rise. Company X and Company Y wish to swap. With the fixed-for-floating swap Company X will pay the floating rate, and thus benefit if in fact interest rates drop, and Company Y will assume payments for the fixed rate loan. Company Y will stand to benefit if interest rates rise.