Interest Rate Swap
An agreement between two parties (known as counterparties) where one stream of future interest payments is exchanged for another based on a specified principal amount. Often, interest rate swaps exchange a fixed payment for a payment that is not fixed, but rather linked to an interest rate (most often the LIBOR). A company will typically use interest rate swaps to limit, or manage, their exposure to fluctuations in interest rates or to obtain a marginally lower interest rate than they would have otherwise been able to without the swap.
Investopedia Commentary
Interest rate swaps are simply the exchange of one set of cash flows (based on interest rate specifications) for another. As they trade OTC, they are really just contracts set up between two or more parties and thus can be customized any number of ways.
Generally speaking, swaps are sought by firms who desire a type of interest-rate structure that another firm can provide less expensively. For example, if Cory's Tequila Company (CTC) is seeking to loan funds at fixed interest rate, but Tom's Sports Inc (TSI) has access to marginally cheaper fixed-rate funds. So, Tom's Sports can issue debt to investors at their low fixed rate, and then trade the fixed-rate cash flow obligations to CTC for floating-rate obligations issued by TSI. Even though TSI may have a higher floating rate than CTC, by swapping the interest structures they are best able to obtain inexpensively, the combined costs are decreased, which can be shared by both parties.
Related Links
Forces Behind Interest Rates
Corporate Use of Derivatives for Hedging
See also: Basis Rate Swap, Currency Swap, Fixed Interest Rate, Floating Exchange Rate, Hedge, Interest Sensitive Stock, Notional Principal Amount, Spreadlock, Swap, Total Return Swap
Also spelled: Interest-rate swap