Business Glossary

contract in which two counter-parties agree to exchange interest payments of differing character based on an underlying notional principal amount that is never exchanged. There are three types of interest swaps: coupon swaps or exchange of fixed rate for floating rate instruments in the same currency; basis swaps or the exchange of floating rate for floating rate instruments in the same currency; and cross currency interest rate swaps involving the exchange of fixed rate instruments in one currency for floating rate in another.

Typically, a swap contract exchanges fixed rate obligations for a floating rate instrument in the same currency. In its simplest form, the two parties to an interest rate swap exchange their interest payment obligations (no principal changes hands) on two different kinds of debt instruments, one being a fixed interest rate, the other being a floating rate.

For example, the Student Loan Marketing Association (Sallie Mae) may want to swap rates with a mutual savings bank-a mutually beneficial transaction, as Sallie Mae, a highly rated institution because of its status as a federal agency, prefers floating rate to match short-term loans in its student loan portfolio. Sallie Mae can sell fixed rate debt at a relatively low cost, whereas the mutual savings bank prefers to match its long-term fixed rate mortgages with fixed rate funds.

contractual agreement between two parties in which they agree to exchange a stream of interest payments on either a fixed rate for a floating rate or a floating rate for a fixed rate. The insurance company is most likely to select a floating rate for a fixed rate because it needs to know exactly what it will be paying in future interest. In this way, the insurance company can hedge its interest rate exposure (risk that interest rates will rise or fall at some stipulated time), reflected by changes in the value of its assets on the balance sheet.

contractual agreement entered into between two counterparties under which each agrees to make periodic payments to the other for an agreed period of time based upon an amount of principal . A common form occurs when a series of payments calculated by applying a fixed rate of interest to a notional principal amount is exchanged for a stream of payments similarly calculated but using a floating rate of interest. Aswap may also be used to effectively change the maturity term of a debt. The two parties are often a corporation and a bank; the bank in turn likely hedges the transaction with a derivative product tied to U.S. Treasury bonds.