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What is a Swap Contract? - Definition & Examples

Instructor: Roderick Powell

Roderick has taught college Economics and has a master's degree in business.

This lesson describes and explains the mechanics of interest rate swaps and other swap contracts. You'll also learn how swaps are used by borrowers and investors to reduce risk, add risk, or exchange one type of risk exposure for another.

Turning Metal Into Gold

Ancient scientists tried unsuccessfully for hundreds of years to turn base metals into precious gold. The alchemists, as they were called, eventually gave up. The act of transmutation, turning one thing into another, did not work for the alchemists. However, the concept of transmutation lives on in the world of derivatives. Derivatives are financial instruments that are derived or based on some other financial instrument. In the case of an interest rate swap, it is derived from fixed and floating rate bonds. While you cannot turn a base metal into gold, you can convert a floating rate loan into a fixed rate loan. The folks who developed the means to do this using interest rate swaps are like modern-day alchemists known on Wall Street as financial engineers.

What is an Interest Rate Swap?

An interest rate swap is a contract between two parties where one party agrees to exchange a stream of payments based on a fixed interest rate with a stream of payments based on a floating interest rate for a specified term to maturity. The interest payment is based on a specified notional principal amount. Swaps can be used to bet on the future direction of interest rates or for hedging against the adverse impact of changes in interest rates. The party who receives payments based on a fixed rate makes payments based on a floating rate has a position similar to holding a fixed-rate bond. If rates decrease, the value of the swap position will increase. The same as if the party had invested in a fixed-rate bond.

Therefore, instead of purchasing a bond, if you think rates will decrease, an investor could enter into an interest rate swap agreement to receive a fixed rate of interest. The primary difference is that when you enter into a swap no cash changes hands. The principal amount is simply a notional amount or bookkeeping entry that interest payments is based on. On the other hand, when you purchase a fixed-rate bond, cash does exchange hands. The investor has to pay the principal amount to the seller of the bond.

Changing a Floating Rate Loan into a Fixed Rate Loan

One of the biggest benefits of the swap market is that it allows a borrower to convert a floating rate loan into a fixed rate loan. Suppose a company borrows one million dollars from a bank. The rate on the loan floats monthly based on changes in the one-month LIBOR interest rate. If rates subsequently rise, the company's interest expense will increase. If the borrower wants to mitigate its exposure to the possibility of rising rates, the company can enter into a one million dollar national interest rate swap contract where they receive interest based on a floating rate and pay interest based on a fixed rate.

In this case, if rates increase, the higher interest expense on the loan will be offset by the higher interest income received from the swap contract. In Wall Street vernacular, the combination of a floating rate loan and an interest rate swap has created a synthetic fixed rate loan. This is financial alchemy in action. If, for some financial reason, a company takes out a fixed rate loan and wants to convert it into a synthetic floating rate loan, then they could enter into a swap to receive interest based on a fixed rate and pay interest based on a floating rate on the amount of the loan.

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