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Interest Rate Swaps
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.
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.
There are three different types of interest rate swaps: Fixed-to-floating, floating-to-fixed, and float-to-float.
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.
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.
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 a also switch to a different index, such as the federal funds rate, commercial paper, or the Treasury bill rate.