Interest Rate Swap Agreement | Definition Guide | What is it?

Interest Rate Swap Agreement

Interest Rate Swap Agreement Definition

A binding agreement between counterparties to exchange periodic interest payments on some predetermined dollar principal, which is called the notional principal amount. Interest rate swaps are the most common type of swap Normally at each payment or "settlement date,” the party who owes more pays the net amount; so at any given settlement date only one party actually makes a payment. The notional principal itself is never exchanged.

Often one set of payments in an interest rate swap is determined by the Eurodollar (LIBOR) rate, while the other set is fixed at a rate that corresponds to the yield on a Treasury note of comparable maturity plus some additional basis points. However, other types of arrangements are possible, such as tying both sets of payments to different variable rates. The term structure of interest rates and the forward rates implied by the relationship between short and long term rates are critical factors in evaluating interest rate swaps.

The simplest interest swap is called the "plain vanilla" or "fixed for floating rate swap." For example, if a company has a floating rate loan of $10 million with a bank and believes that interest rates will rise, the company may enter into a fixed for floating rate swap with the bank. For the purposes of the swap, the existing loan principal becomes the notional principal. The company agrees to pay the bank a fixed rate of interest of 9%, on the notational principal according to a 3-year schedule of payments. In exchange, the bank agrees to pay the company interest at the LIBOR (Eurodollar) rate in effect six months prior to each settlement date. The company in effect buys a claim on a series of floating interest payments by agreeing to make fixed interest payments, giving the company the benefits of a fixed rate loan without incurring additional loan origination/conversion costs.

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