An interest rate swap is an investment vehicle in which two or more parties exchange revenue streams from various assets. These swaps can be purchased as a form of insurance to cover an investor in the event that a revenue-generating asset loses value, or they can be purchased as a means of speculating financially. When swaps terminate, the parties involved in the swap will generally settle up the account, with one party paying the other.
A traditional swap involves two parties. One of these parties has an asset that generates revenue at a fixed rate, while the other has an asset that generates revenue at a variable rate. The two parties agree to swap revenue streams from these assets for a set period of time. When this time period has expired, the agreement can be said to have been terminated. However, some contracts can terminate early under certain conditions.
When a contract terminates, one party will generally be required to pay the other party a certain amount of money. This amount is equivalent to the amount by which the revenue generated by his asset exceeded the revenue generated by the other person's asset over the time period of the swap. As per the terms of the swap, the person with the asset that generated more revenue must pay out this money to the other party.
Although many swaps mandate that parties only exchange money when the contract terminates, others are structured so that the two parties exchange money regularly. For example, a swap may be structured so that one party pays the other party on a monthly basis. As with contracts in which money is exchanged after termination, under a swap with periodic payments, the party with the asset that generated more revenue since the last payment must pay the other party.
Some swaps have early termination clauses. Under these clauses, the swapping of revenues ends before the period originally specified in the contract. This early termination may be triggered by a number of events, as specified in the swap agreement. In many contracts, if one asset is generating too much or too little revenue, the contract will be terminated. For example, if the interest rate spikes too high, a swap involving an asset with a variable rate of revenue might be terminated.