# Interest Rate Swap: Definition, Types, and Real-World Example

## What Is an Interest Rate Swap?

Interest rate swaps involve exchanging one stream of interest payments for another to manage exposure to interest rate fluctuations or achieve better borrowing terms. Typically, this swap involves converting fixed-rate payments to floating rates or vice versa. These swaps can be tailored to fit specific financial needs and are commonly used by companies to optimize cash flows.

### Key Takeaways

*   An interest rate swap involves exchanging one stream of future interest payments for another using a specified principal amount.
*   The most common types of interest rate swaps include fixed-to-floating, floating-to-fixed, and float-to-float.
*   Interest rate swaps allow companies to manage exposure to interest rate fluctuations or to obtain favorable borrowing terms.
*   These swaps are traded over-the-counter and can be customized to match the financial needs of the participating parties.
*   The Secured Overnight Financing Rate (SOFR) has replaced LIBOR as the benchmark index for interest rate swaps.

![Interest Rate Swap](https://www.investopedia.com/thmb/bXhroDC7n0coXooU5y-hreHz3cw=/1500x0/filters:no_upscale():max_bytes(150000):strip_icc()/interest-rate-swap-4194467-1-d72db15d28f64e9b801fe940e5999c51.jpg)

*— Joules Garcia / Investopedia*

## How Interest Rate Swaps Work

Interest rate swaps involve exchanging [cash flows](https://www.investopedia.com/terms/c/cashflow.asp) and are traded [over the counter (OTC)](https://www.investopedia.com/terms/o/otc.asp), allowing two or more parties to customize them to meet their needs.

Companies use swaps when they can borrow at one interest rate type but prefer another.

## Different Types of Interest Rate Swaps Explained

There are three different types of interest rate swaps: fixed-to-floating, floating-to-fixed, and float-to-float.

### Fixed-to-Floating

Consider a company named TSI that can issue a bond at a very attractive [fixed interest rate](https://www.investopedia.com/terms/f/fixedinterestrate.asp) 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](https://www.investopedia.com/terms/c/counterparty.asp) bank in which the company receives a fixed rate and pays a floating rate.

The 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)](https://www.investopedia.com/secured-overnight-financing-rate-sofr-4683954#:~:text=Understanding%20the%20Secured%20Overnight%20Financing%20Rate%20%28SOFR%29&text=Interest%2Drate%20swaps%20are%20agreements,for%20floating%2Drate%20interest%20payments.). TSI then receives the SOFR plus or minus a spread that reflects both interest rate conditions in the market and its credit rating.

> **Important**
>
> 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.

### Floating-to-Fixed

A 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](https://www.investopedia.com/terms/t/tenor.asp), 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.

### Float-to-Float

Companies sometimes enter into a swap to change the type or tenor of the [floating rate](https://www.investopedia.com/terms/f/floatinginterestrate.asp) index that they pay; this is known as a basis swap. 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](https://www.investopedia.com/terms/f/federalfundsrate.asp), [commercial paper](https://www.investopedia.com/articles/investing/070313/introduction-commercial-paper.asp), or the [Treasury bill rate](https://www.investopedia.com/ask/answers/012815/how-are-treasury-bill-interest-rates-determined.asp).

## A Real-World Example: PepsiCo’s Interest Rate Swap

Suppose 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](https://www.investopedia.com/terms/c/corporatebond.asp) 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](https://www.investopedia.com/terms/f/financial-exposure.asp) to exchange-rate fluctuations.

## Why Is It Called Interest Rate Swap?

The name is derived from two [parties exchanging (swapping) future interest payments](https://www.investopedia.com/articles/investing/050715/how-read-interest-rate-swap-quotes.asp) based on a specified principal amount. Interest rate swaps are traded in over-the-counter (OTC) markets and are designed to suit the needs of each party. The most common swap is a fixed exchange rate for a floating rate. This is also known as a vanilla swap.

## Why Do Companies Engage in Interest Rate Swaps?

The primary reasons why financial institutions use interest rate swaps are to [hedge](https://www.investopedia.com/terms/h/hedge.asp) against losses, manage [credit risk](https://www.investopedia.com/terms/c/creditrisk.asp), or [speculate](https://www.investopedia.com/terms/s/speculation.asp).

## What's an Example of an Interest Rate Swap?

Say that Company A issued $10 million in two-year bonds that have a variable interest rate of SOFR plus 1%. SOFR is 2% but the company is worried that interest rates may rise. It locates Company B, which agrees to pay Company A the SOFR annual rate plus 1% for two years on the [notional principal amount](https://www.investopedia.com/terms/n/notionalprincipalamount.asp) of $10 million. In exchange, Company A pays Company B a fixed rate of 4% on a notional value of $10 million for two years. If interest rates rise significantly, Company A will benefit. Conversely, Company B will stand to benefit if interest rates stay flat or fall.

## The Bottom Line

Interest rate swaps enable parties to exchange one set of interest payments for another to manage exposure to fluctuating rates or secure better borrowing terms. These over-the-counter (OTC) derivative contracts are customizable and typically involve swapping fixed-rate payments for floating-rate ones. Businesses utilize interest rate swaps to hedge against interest rate fluctuations, capitalize on market conditions, and align cash flows with their financial strategies.

> **Article Sources**
>
> 1.  Jennifer N. Carpenter, NYU Leonard N. Stern School of Business. "[Interest Rate Swaps Slides](https://pages.stern.nyu.edu/~jcarpen0/courses/b403333/10swap.pdf)." Page 2.
>     
> 2.  PIMCO. "[Understanding Interest Rate Swaps](https://www.pimco.com/us/en/resources/education/understanding-interest-rate-swaps)."
>     
> 3.  Commodity Futures Trading Commission. "[CFTC Swaps Report Data Dictionary](https://www.cftc.gov/sites/default/files/idc/groups/public/@swapsreport/documents/file/propdatadict.pdf)." Page 2.
>     
> 4.  Intercontinental Exchange. “[LIBOR®](https://www.theice.com/iba/libor).”