Interest rate swaps are over-the-counter derivative contract-exchange agreements made by two or more parties. Interest rate swaps occur when one party agrees to swap a stream of future interest payments for the other party’s stream of future interest payments. All parties involved agree upon the time period during which the interest swap will last. There are three main types of interest rate swaps.
Fixed for Floating
Investors call the parts of interest swap agreements “legs.” In a fixed-for-floating swap agreement, one party agrees to pay the fixed leg of the swap, with the other party agreeing to pay the floating leg of the swap. The fixed rate is the interest charged over the life of a loan and does not change. The floating rate is an interest rate pegged to an international reference rate index and is subject to change. The most commonly used reference rate is London Interbank Offered Rate or LIBOR.
Floating for Floating
In a floating-for-floating interest rate swap agreement, both parties agree to pay a floating rate on their respective legs of the swap. The floating rates for each leg of the swap generally come from different reference rate indexes, but can also come from the same index. If both parties choose the same index, generally they then choose different payment dates. The two main indexes investors use in a floating for floating interest rate swap are the LIBOR and the Tokyo Interbank Offered Rate or TIBOR
Fixed for Fixed
In fixed-for-fixed interest rate swaps, both parties agree to a fixed interest for their respective legs of the swap. The interest rate does not change over the life of the loan for both parties. Investors most commonly use fixed-for-fixed interest rate swaps when they are dealing with different currencies. Companies often use fixed-for-fixed interest rate swaps when they are building or expanding their business in a foreign country.