Loading the player...

What is an 'Interest Rate Swap'

An interest rate swap is a forward contract in which one stream of future interest payments is exchanged for another based on a specified principal amount. Interest rate swaps usually involve the exchange of a fixed interest rate for a floating rate, or vice versa, to reduce or increase exposure to fluctuations in interest rates or to obtain a marginally lower interest rate than would have been possible without the swap.

A swap can also involve the exchange of one type of floating rate for another, which is called a basis swap.

BREAKING DOWN 'Interest Rate Swap'

Interest rate swaps are the exchange of one set of cash flows for another. Because they trade over the counter (OTC), the contracts are between two or more parties according to their desired specifications and can be customized in many different ways. Swaps are often utilized if a company can borrow money easily at one type of interest rate but prefers a different type.

Fixed to Floating

For example, consider a company named TSI that can issue a bond at a very attractive fixed interest rate to its investors. The company's management feels that it can get a better cash flow from a floating rate. In this case, TSI can enter into a swap with a counterparty bank in which the company receives a fixed rate and pays a floating rate. The swap is structured to match the maturity and cash flow of the fixed-rate bond, and the two fixed-rate payment streams are netted. TSI and the bank choose the preferred floating-rate index, which is usually LIBOR for a one-, three- or six-month maturity. TSI then receives LIBOR plus or minus a spread that reflects both interest rate conditions in the market and its credit rating.

Floating to Fixed

A company that does not have access to a fixed-rate loan may borrow at a floating rate and enter into a swap to achieve a fixed rate. The floating-rate tenor, reset and payment dates on the loan are mirrored on the swap and netted. The fixed-rate leg of the swap becomes the company's borrowing rate.

Float to Float

Companies sometimes enter into a swap to change the type or tenor of the floating rate index that they pay; this is known as a basis swap. A company can swap from three-month LIBOR to six-month LIBOR, for example, either because the rate is more attractive or it matches other payment flows. A company can also switch to a different index, such as the federal funds rate, commercial paper or the Treasury bill rate.

RELATED TERMS
  1. Liability Swap

    A liability swap is a financial derivative in which two parties ...
  2. Delayed Rate Setting Swap

    A delayed rate setting swap is an exchange of cash flows, one ...
  3. Swap Curve

    A swap curve identifies the relationship between swap rates at ...
  4. Forward Swap

    A forward swap is an agreement between two parties to exchange ...
  5. Amortizing Swap

    An amortizing swap is an exchange of cash flows, one fixed rate ...
  6. Plain Vanilla Swap

    A plain vanilla swap is the most basic type of forward claim ...
Related Articles
  1. 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.
  2. Trading

    An Introduction To Swaps

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

    What Warren Buffet Calls "Weapons of Mass Destruction": Understanding the Swap Industry

    A full analysis of how the swap industry works.
  4. 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
  5. Trading

    Derivatives 101

    Learn how to use derivatives to hedge, speculate or increase leverage in an investment portfolio.
  6. Investing

    Float Over to Floating Rate ETFs

    Floating rate notes are another avenue for bond investors to consider when it comes to reducing interest rate risk.
  7. Insights

    Who Uses Libor Data And Why?

    LIBOR is a crucial benchmark reference rate with global economic impact.
  8. 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.
  9. Trading

    Dual And Multiple Exchange Rates 101

    Why would a country choose to implement dual or multiple exchange rates? It's risky, but it can work.
  10. Investing

    What is the OIS LIBOR spread, and what is it for?

    When the LIBOR-OIS spread rises significantly, it represents the worry that banks might not be able to pay down even their short-term debt obligations.
RELATED FAQS
  1. How do companies benefit from interest rate and currency swaps?

    Interest rate and currency swaps help companies manage exposure to rate fluctuations and acquire a lower rate than they would ... Read Answer >>
  2. When was the first swap agreement and why were swaps created?

    Learn about the history of swap agreements, the first swap agreement between IBM and the World Bank, and how swaps have evolved ... Read Answer >>
  3. What is the difference between derivatives and options?

    A derivative is a financial contract that gets its value from an underlying asset. Options offer one type of common derivative. Read Answer >>
  4. What exactly is a company's float?

    The term "float" refers to the regular shares that a company has issued to the public that are available for investors to ... Read Answer >>
Trading Center