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An interest rate swap is a contract to exchange fixed payments for floating payments linked to an interest rate, and is generally used to manage exposure to fluctuations in interest rates.
The over-the-counter derivatives sector is dominated by interest rate swaps which have grown massively in recent years, partly driven by speculators. As of December 2009, there were some $349,276bn of outstanding swaps, according to the Bank of International Settlements. In a swap transaction, investors exchange or “swap” two types of interest payments – one a fixed rate, the other a floating rate – over the lifetime of a deal. The swap rate is the cost of switching from a floating rate to a fixed rate. The floating rate is determined by the three-month London Interbank Offered Rate used as a benchmark for floating rate mortgages and loans.
The appeal of swaps is that they help companies, portfolio managers and banks to manage cash flows by fixing interest payments over time. But if markets move in an unexpected way, they can also produce losses. Typically in a swap the “payer” (a bank, say) agrees to pay a fixed rate for the term of the contract; in return the “receiver” (a company, say) pays a floating rate. If rates rise the “payer” profits, getting a floating rate higher than their fixed payments. Conversely, if rates fall the “receiver” benefits, with the fixed payments received higher than the prevailing rate paid out.