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.
- A fixed-for-floating swap occurs when one party swaps the interest cash flow of a fixed-rate loan with those of a floating-rate loan held by another party.
- Doing the swap reduces interest expense by swapping for a floating rate if it is lower than the fixed-rate currently being paid.
- A fixed-for-floating swap allows you to better match assets and liabilities that are sensitive to interest rate movements.
Understanding 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 a 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 London Interbank Offered Rate (LIBOR) + 3.50% (floating rate loan), has the 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. Swap transactions are facilitated by a swap dealer, who will act as the required counterparty for a fee.