Interest rate swaps

In the world of finance the terms “interest rate swap” and “swaps” come up frequently — but what do they actually mean? In this post we explain what an interest rate swap is and give some concrete examples to help you understand how they work and what they are used for.

An interest rate swap is a financial derivative that lets two parties exchange interest payments over a given period. In practice it means they can switch between a fixed and a floating rate, depending on their financial needs. Suppose Company A has a loan with a fixed rate of 5% and Company B has a loan with a floating rate tied to a reference rate. By entering into an interest rate swap, the two companies can exchange their interest payments: Company A pays the floating rate tied to the reference rate, while Company B pays the fixed 5%.

Beyond interest rate swaps there are other kinds of swaps, such as currency swaps and commodity swaps. A swap is fundamentally an agreement between two parties to exchange (swap) something — an interest rate, a currency, or even corporate cash flows. As an example of another type, imagine Company C has a payment in euros and Company D has a payment in US dollars. Through a currency swap, they can exchange their payments to avoid currency risk and potential losses from exchange-rate fluctuations.

Interest rate swaps — and swaps in general — are important financial instruments for managing risk and fine-tuning interest-rate and currency positions. Used well, they help companies protect themselves against uncertainty and build a more stable financial foundation.

In Onefin’s platform you can administer every type of swap and other interest-rate derivatives, with key figures showing how they affect the portfolio’s fixed-rate tenor, interest cost and risk profile.