Interest Rate Swap – Definition

Cite this article as:"Interest Rate Swap – Definition," in The Business Professor, updated May 30, 2019, last accessed June 3, 2020, https://thebusinessprofessor.com/lesson/interest-rate-swap-definition/.

Back to: ECONOMICS, FINANCE, & ACCOUNTING

Interest Rate Swap Definition

An interest rate swap is a form of contract where the parties agree to exchange or swap the interest payments on two securities. It is primarily a tool used by bond investors.

A company that has issued corporate bonds seeks to improve its cash flow. It seeks to change the fixed rate on its corporate bonds for a floating rate. In this situation, the company can enter a swap with a counter-party bank wherein the company gets a fixed rate and also pays a floating rate.

This rate exchange transaction is designed to match both the cash flow and maturity of the fixed-rate bond, and thus, the two fixed-rate streams of payment are netted. The company the bank decide on the floating-rate index. Generally, this agreements uses LIBOR for maturity rates of one month, three months, or six months. The company would get the London Inter-bank Offer Rate plus/minus a spread which shows interest rate market conditions. There may also be a discount or premium based upon the company’s credit rating.

Floating to Fixed

A company which has no access to a fixed-rate loan can decide to borrow at a rate that’s floating, thus entering into a swap in a bid to accomplish a fixed rate. The tenor, reset, and payment dates for the floating rates stated on the loan, reflect on the swap and are netted. The swap’s fixed-rate leg then becomes the borrowing rate of the company.

Float to Float

Sometimes, companies enter into a swap in order to change the floating rate index type or tenor that they pay. This is referred to as a basis swap. A company is capable of swapping from LIBOR of three months to that of six months. For instance, either because it has a more attractive rate or because it corresponds with other flows of payment. A company is also capable of switching to an entirely different index like the commercial paper, federal funds rate, or the Treasury bill rate.

References for Interest Rate Swap

Research articles for Interest Rate Swap

An econometric model of the term structure of interestrate swap yields, Duffie, D., & Singleton, K. J. (1997). The Journal of Finance, 52(4), 1287-1321.

An analytic solution for interest rate swap spreads, Grinblatt, M. (2001). International Review of Finance, 2(3), 113-149.

Fiscal policy events and interest rate swap spreads: Evidence from the EU,  Afonso, A., & Strauch, R. (2007). Journal of International Financial Markets, Institutions and Money, 17(3), 261-276.

An economic analysis of interest rate swaps, Bicksler, J., & Chen, A. H. (1986). The Journal of Finance, 41(3), 645-655.

Determinants of interest rate swap spreads, Lang, L. H., Litzenberger, R. H., & Liu, A. L. (1998). Journal of Banking & Finance, 22(12), 1507-1532.

The market price of credit risk: An empirical analysis of interest rate swap spreads, Liu, J., Longstaff, F. A., & Mandell, R. E. (2002). (No. w8990). National Bureau of Economic Research.

Interest rate swaps and corporate financing choices, Titman, S. (1992).The Journal of Finance, 47(4), 1503-1516.

Expected budget deficits and interest rate swap spreads-Evidence for France, Germany and Italy, Heppke-Falk, K., & Hüfner, F. P. (2004).

Identifying the factors that affect interestrate swap spreads: some evidence from the United States and the United Kingdom, Lekkos, I., & Milas, C. (2001). Journal of Futures Markets: Futures, Options, and Other Derivative Products, 21(8), 737-768.

The components of interest rate swap spreads: Theory and international evidence, Fehle, F. (2003).

Was this article helpful?