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What is an Interest Rate Swap?

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  • Written By: Malcolm Tatum
  • Edited By: Bronwyn Harris
  • Last Modified Date: 04 August 2018
  • Copyright Protected:
    2003-2018
    Conjecture Corporation
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Interest rate swaps are situations in which two or more parties agree to swap or exchange interest payments on specific liquid instruments, at least for a specific period of time. In some applications, the interest rate swap involves exchanging interest payments for the cash flow on an asset controlled by a different party. A swap of this kind can even involve two companies choosing to swap interest generated on payables or receivables for a certain amount of time.

All approaches of the interest rate swap have one common goal, which is to benefit all participants in some manner. Two of the more common advantages to this type of arrangement is that everyone experiences some amount of savings on interest payments, as well as creating a more favorable balance between the influx of cash and the outgo of resources to meet specific financial obligations. This approach can be an ideal way for two companies to assist one another during an economic downturn, since each can make use of liquid instruments that benefit the other without creating any significant stress on the ability of either party to continue operating normally.

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It is not unusual for an interest rate swap to be crafted with specific start and end dates. This is to the benefit of all parties concerned. Should economic changes take place that render the swap ineffectual or even potentially damaging to one or more parties, there is only a certain amount of time to address when negotiating terms to nullify the working agreement. The use of start and end dates also allows each party to assess the benefits received during the life of the swap, and decide if it is in the best interests of the company to renew the swap contract for a second time period.

When crafting an interest rate swap, any type of interest income can be utilized as part of the agreement. One party may choose to use financial instruments that carry a fixed rate, while another party may prefer to utilize instruments that provide a variable or floating rate. As long as all parties are satisfied with the potential benefit derived from the swap, using a mixture of fixed assets and floating assets is not likely to create any problems for the swap participants.

An interest rate swap does have some advantages over other types of financial strategies. For example, there is no risk at all to any principal amount, since the swap is focused on the exchange of cash flows based on interest earned on specified assets or liabilities. The ability to create a swap agreement that is short-term also means there is no lengthy commitment, as would be the case with many types of loans. The simplicity of an interest rate swap, plus the speed with which this type of agreement can be implemented, make it a popular funding option for businesses and other entities around the world.

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