Interest rate swap
Principles of Finance glossary · Valuation of Bonds & Stocks
Definition
An agreement to exchange fixed-rate for floating-rate interest payments on a notional amount.
Interest rate swap in plain English
Some loans charge a fixed interest rate (the payment never changes), while others charge a floating rate that rises and falls with the market. In an interest rate swap, two parties agree to trade their interest payments: one pays the other a fixed rate, and in return receives a floating rate, or vice versa. Nobody swaps the actual loan, just the interest, calculated on an agreed reference amount called the "notional" (a stated figure used only to size the payments, never handed over). It's like two friends trading phone plans, one wants the predictability of a flat monthly bill, the other is fine with a bill that changes, so they swap who bears which, without moving the phones themselves. Companies use swaps to turn unpredictable interest costs into steady ones, or the reverse.
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