Interest Rate Swap

An interest rate swap is a type of swap agreement in which two parties agree to exchange interest rate cash flows, based on a specified notional amount. Interest rate swap can be used for both hedging and speculation. In interest rate swap, parties never exchange the principal amount.

Example:

Suppose company A takes a $1 million loan with a variable rate of interest defined as LIBOR + 2%. Assume another company B borrows $1 million from another lender with a fixed rate of interest of 8%. Both companies are not happy with their contracts. Company A doesn’t like the variability and unpredictability with their interest. Companies B feels they are overpaying for their interest. So both companies agree to enter into an interest rate swap contract. Under the terms of the contract, Company A agrees to pay Company B  8% per year on $1 million notional amount. Company B agrees to pay Company A LIBOR + 2% per year on $1 million.