An interest rate swap is an agreement to exchange interest payments from a financial instrument for interest payments from another financial instrument.
This usually involves trading future interest payments from an instrument with a fixed interest rate for one with a floating or variable rate, or vice-versa. This is usually undertaken to increase or decrease your exposure to changes in interests rates, or possibly to secure a lower interest rate than would otherwise be available. However, interest rate swaps can involve swapping one floating rate for another. This is known as a ‘basis swap’.
Ultimately, interest rate swaps come down to two or more parties agreeing to swap one set of cash flows for another. A company may only be able to secure a loan at a floating rate, for example, but would prefer to be exposed to a fixed rate, and therefore look to swap interest rates with another party.
