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Interest Rate Swap

An interest rate swap is a financial contract in which two parties exchange interest rate cash flows based on a specified notional principal. Typically, one party pays a fixed interest rate while the other pays a floating rate, such as LIBOR. Interest rate swaps are used by businesses and investors to manage or hedge interest rate risk, allowing them to switch between fixed and floating rate exposures depending on market conditions.

Example

A company with a floating-rate loan might enter into an interest rate swap to pay a fixed rate instead, protecting itself from potential interest rate increases.

Key points

• A financial contract where two parties exchange interest rate payments.

• Typically involves swapping fixed and floating rate cash flows.

• Used to manage or hedge interest rate risk.

Quick Answers to Curious Questions

Companies use swaps to manage exposure to interest rate fluctuations, converting floating rate liabilities to fixed rates or vice versa.

Swaps allow companies to hedge against interest rate risk, optimize their debt structure, and reduce exposure to unfavorable market changes.

One party agrees to pay a fixed interest rate while the other pays a floating rate, with both payments based on a notional amount, though the principal is not exchanged.