What is an Interest Rate Swap?

An interest rate swap is a form of contract where the parties agree to exchange or swap the interest payments on two securities. It is primarily a tool used by bond investors. A company that has issued corporate bonds seeks to improve its cash flow. It seeks to change the fixed rate on its corporate bonds for a floating rate. In this situation, the company can enter a swap with a counter-party bank wherein the company gets a fixed rate and also pays a floating rate. This rate exchange transaction is designed to match both the cash flow and maturity of the fixed-rate bond, and thus, the two fixed-rate streams of payment are netted. The company the bank decide on the floating-rate index. Generally, this agreements uses LIBOR for maturity rates of one month, three months, or six months. The company would get the London Inter-bank Offer Rate plus/minus a spread which shows interest rate market conditions. There may also be a discount or premium based upon the company's credit rating.

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Floating to Fixed

A company which has no access to a fixed-rate loan can decide to borrow at a rate that's floating, thus entering into a swap in a bid to accomplish a fixed rate. The tenor, reset, and payment dates for the floating rates stated on the loan, reflect on the swap and are netted. The swap's fixed-rate leg then becomes the borrowing rate of the company.

Float to Float

Sometimes, companies enter into a swap in order to change the floating rate index type or tenor that they pay. This is referred to as a basis swap. A company is capable of swapping from LIBOR of three months to that of six months. For instance, either because it has a more attractive rate or because it corresponds with other flows of payment. A company is also capable of switching to an entirely different index like the commercial paper, federal funds rate, or the Treasury bill rate.