Interest Rate Swap

An interest rate swap is an agreement in which two parties make interest payments to each other for a set period based upon a notional principal. The notional principal is only used to calculate the interest payments; no risk is attached to it. Interest rate swaps commonly involve exchanging payments based on a fixed interest rate for payments based on a floating rate, often LIBOR. For example, party A pays a fixed rate to to party B and receives a variable rate in exchange from party B. The fixed rate is known as the swap rate. The payments may also both be based on floating rates, for example LIBOR and commercial paper rates. Only the difference between the two interest payments changes hands. Companies take out swap agreements to hedge against interest rate exposure, to speculate on future interest rate movements or to obtain a higher yield on their assets.

See also: Derivatives