Interest Rate Swap Explained 2025: Types, Examples & Pricing Insights

Gordon Scott brings over two decades of investing and technical analysis expertise. He holds the Chartered Market Technician (CMT) designation.

What Is an Interest Rate Swap in 2024?

An interest rate swap is a financial contract where two parties exchange streams of future interest payments, calculated on a specified principal amount. This exchange typically involves swapping fixed interest rate payments for floating rate payments or vice versa, helping parties manage risks linked to fluctuating interest rates or achieve more favorable borrowing costs.

Another variant is the basis swap, where one floating rate is exchanged for another floating rate, catering to specific financial strategies.

Key Highlights

• Interest rate swaps are forward contracts exchanging future interest payment streams based on a principal amount.
• They can swap fixed and floating rate payments to adjust exposure to interest rate volatility.
• Often referred to as plain vanilla swaps due to their straightforward structure.
• The Secured Overnight Financing Rate (SOFR) now serves as the primary benchmark index, replacing LIBOR.

How Interest Rate Swaps Work

Interest rate swaps involve exchanging cash flows between parties in over-the-counter (OTC) markets, allowing tailored contract terms to meet each party’s financial objectives. Companies use swaps to adjust their interest rate exposure, especially when they can borrow at one type of rate but prefer another.

Types of Interest Rate Swaps in 2024

There are three primary types of interest rate swaps:

Fixed-to-Floating Swap

For example, a company like TSI may issue bonds at a fixed interest rate but desire floating-rate cash flows. TSI could enter a swap agreement to receive fixed payments while paying floating-rate interest, usually linked to SOFR, effectively converting its fixed-rate obligation into a floating rate.

Floating-to-Fixed Swap

A company that only has access to floating-rate loans may swap those payments for fixed-rate payments to stabilize costs. The floating-rate loan terms are mirrored in the swap, and the fixed leg becomes the effective borrowing rate.

Float-to-Float Swap (Basis Swap)

Companies might swap one floating-rate index for another, such as switching from three-month SOFR to six-month SOFR, to better match cash flow needs or take advantage of more favorable rates.

Important Regulatory Update

LIBOR ceased publication of its main rates on June 30, 2023, with synthetic USD LIBOR rates available until September 30, 2024, under UK FCA supervision, prompting widespread adoption of SOFR.

Practical Example: PepsiCo’s Interest Rate Swap Strategy

PepsiCo needs $75 million to acquire a company. Borrowing in the U.S. costs 3.5%, but foreign markets offer 3.2% in local currency, exposing PepsiCo to currency risk. By entering an interest rate swap, PepsiCo locks in the 3.2% interest payments for the life of the bond, swapping currency and interest payments to mitigate exchange rate volatility.

Why the Name "Interest Rate Swap"?

The term arises from the contract’s nature—two parties "swap" future interest payments based on an agreed notional principal. These OTC derivatives are highly customizable, with the most common form being a fixed-for-floating rate exchange, also known as a vanilla swap.

Why Do Companies Use Interest Rate Swaps?

Financial institutions and corporations engage in interest rate swaps primarily to hedge interest rate risk, optimize borrowing costs, manage credit exposure, or speculate on interest rate movements.

Example Scenario

Consider Company A, which issues $10 million in two-year bonds at SOFR plus 1%. Concerned about rising rates, it swaps payments with Company B, paying a fixed 4% rate while receiving SOFR plus 1%. If rates rise, Company A benefits; if rates fall, Company B gains.

Conclusion

Interest rate swaps are versatile financial tools that enable parties to tailor their interest rate exposure, reduce risk, and optimize financing costs. By exchanging fixed and floating interest payments over specified timeframes, companies can strategically manage their borrowing and investment requirements in dynamic market conditions.

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