what is an interest rate swap 
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 1interest rate swaps usually involve the exchange of a fixed interest rate payment for a floating rate payment 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 joules garcia investopediaunderstanding interest rate swapsinterest 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 are structured according to their desired specifications and can be customized in many different ways 2swaps are often utilized if a company can borrow money easily at one type of interest rate but prefers a different type types of interest rate swapsthere are three different types of interest rate swaps fixed to floating floating to fixed and float to float consider a company named tsi that can issue a bond at a very attractive fixed interest rate to 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 3the swap is structured to match the maturity and cash flow of the fixed rate bond and the two payment streams are netted tsi and the bank choose the preferred floating rate index which is usually the secured overnight financing rate sofr tsi then receives the sofr plus or minus a spread that reflects both interest rate conditions in the market and its credit rating the ice benchmark administration limited the authority responsible for libor stopped publishing rates as of june 30 2023 however it still publishes what it calls synthetic 1 month 3 month and 6 month usd libor rates under order by the uk financial conduct authority this will end on sept 30 2024 4a company that does not have access to a fixed rate loan may borrow at a floating rate and enter into a swap to acquire 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 3 a company can swap from the three month sofr to six month sofr for example because the rate either is more attractive or matches other payment flows a company can also switch to a different index such as the federal funds rate commercial paper or the treasury bill rate real world example of an interest rate swapsuppose that pepsico needs to raise 75 million to acquire a competitor in the united states they may be able to borrow the money with a 3 5 interest rate but outside of the u s they may be able to borrow at just 3 2 the catch is that they would need to issue the bond in a foreign currency which is subject to fluctuation based on the home country s interest rates pepsico could enter into an interest rate swap for the duration of the bond under the terms of the agreement pepsico would pay the counterparty a 3 2 interest rate over the life of the bond the company would then swap 75 million at the agreed upon exchange rate when the bond matures and avoid any exposure to exchange rate fluctuations 