What does Interest Rate Swap mean?
A derivative instrument to exchange interest cash flows. An interest rate swap is a contract between two parties to exchange cash flows arising from interest bearing securities at particular payment dates.
Futures Knowledge Explains Interest Rate Swap
Interest rate swaps are the most common example of swaps. A simple swap example is a fixed to floating rate swap. Here one party pays a fixed rate of interest and receives a floating rate (generally linked to LIBOR). A swap helps to manage cash inflow and outflow to meet specific financial obligations.
For example, company ABC takes a loan for $400 million at a fixed rate of interest and company XYZ takes a loan for $400 million at a floating rate of interest. Company ABC expects that the rate in future will reduce and thus wants to convert its fixed rate into a floating one. On the other hand, company XYZ perceives that the interest rates will increase in the future and want to convert into a fixed rate loan to safeguard itself. The companies may enter into interest rate swap to hedge their risk.