LIBOR Swap Definition
A swap refers to an exchange in interest rates on loans between two companies, based on a specified principal amount. Typically, companies will exchange fixed for variable rates, usually linked to the London Interbank Offered Rate (LIBOR) in order to lower their interest payments.
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Why Companies Swap Rates
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Company A has a better credit rating and is able to obtain funds at a generally lower floating rate than Company B. By swapping rates, Company B obtains a lower rate while company A eliminates the risk of future rate increases for which it might not be prepared. Rates are swapped by exchanging contracts on an "over-the-counter" market, which means not through a formal exchange, such as the New York Stock Exchange, but through a dealer network.
Types of Swaps
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The most common type of interest rate swap is a fixed-for-floating swap. Here, it is usually the company with the lower credit rating that has a fixed rate loan. Alternatively, companies can swap their floating rates, based on different underlying rates, such as Treasury bills and LIBOR.
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LIBOR Swaps and Mortgages
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Banks usually use short-term LIBOR rates for variable rate mortgages and swaps for fixed-rate ones. If your bank decides to switch from a variable to a fixed-rate mortgage, it will use the swap for that. This Is Money website points out that swaps are usually driven by long-term expectations regarding rates while LIBOR is a shorter-term measure.
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