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Perhaps the greatest tension among investors is balancing profit against certainty, risk vs. reward. Some investors seek confidence. They want to know where their money will be and how much will be there.

Others invest with an eye toward profits. They want to make more money and understand that you can't get to the top floor if you're scared of falling down the stairs.

To help investors balance just the right mix of risk and certainty, there is the interest rate swap.

What Is an Interest Rate Swap?

An interest rate swap (or just a "swap") is an agreement between two parties to exchange one stream of interest payments on a loan or investment for another.

This is what's known as a derivative contract because it is based on another, underlying financial product. In this case the interest rate swap is layered on top of the underlying investments, which pay the interest in question.

Most swaps involve exchanging a fixed interest rate for a floating one in what is called a "vanilla swap." Others exchange one floating interest rate for another. This is called a "basis swap." Parties will rarely, if ever, exchange fixed interest rate payments, as this would typically give one party an unambiguous advantage.

A standard interest rate swap uses the LIBOR as its index for floating interest rates.

Example of an Interest Rate Swap

Consider two investors: Robert and Elizabeth. Elizabeth holds the note on a loan worth $500,000 that pays a fixed 2.5% interest rate per month. Robert also holds the note on a $500,000 loan but with a variable interest rate that pays the LIBOR monthly rate plus 0.5%.

This could play out three possible ways:

1. No Interest Rate Swap - LIBOR Worth 2.5%

The parties don't make a deal. In this case Elizabeth makes $12,500 on her loan every month. Robert collects a floating income based on how the LIBOR moves. This month he makes $15,000.

2. Interest Rate Swap - LIBOR Worth 2.5%

The parties make a deal. Robert and Elizabeth each collect the interest on their loans as before, but now they will pay each other the value of the interest collected.

Elizabeth will pay Robert the $12,500, she collected in her flat-rate payments. Robert will pay Elizabeth the $15,000, he collected in his variable-rate payments. In practice the payments offset and Robert will simply pay Elizabeth the $2,500 difference.

In the final total, Elizabeth collects $15,000 this month and Robert collects $12,500.

3. Interest Rate Swap - LIBOR Worth 1.5%

The parties make a deal, but in this case the LIBOR has gone down significantly.

Elizabeth's loan continues to pay its fixed rate of $12,500 per month, however Robert's loan now pays $10,000. Again, their payments offset and Elizabeth will pay Robert the difference of $2,500.

In the final total, Elizabeth collects $10,000 this month and Robert collects $12,500.

Two Notes

  • First, the language of an interest rate swap can get confusing. Remember that nobody actually loses money on this exchange. Even though one party pays the other, they do so after everyone has collected interest. The payments only serve to ensure that Robert receives his fixed payment every month.
  • Second, again be sure to note that neither Elizabeth nor Robert exchanged the payment on their loan's underlying principle. An interest rate swap deals only with interest payments.

Why Make an Interest Rate Swap

It depends on the type of rate swap.

1. Vanilla Rate Swap - Trading Certainty Against Profit

Most interest rate swaps are of the "vanilla" kind, swapping a floating interest payment for a fixed payment. In this deal, one party wants greater certainty of their cash flow while the other is looking for potentially larger returns.

This is the case in our example above. Elizabeth holds a fixed stream of income from her loan. Conducting an interest rate swap allows her to potentially make more money than she could otherwise. By contrast, Robert has a variable stream of income from his floating interest rate loan. Conducting the interest rate swap allowed him to lock in a predictable cash flow at the expense of potential profits.

2. Basis Swap - Restructuring Income

A basis swap (swapping two floating interest rates) allows the parties to restructure their income. A party might make a basis swap to change the rate at which its interest is calculated, such as changing a monthly rate of return to an annual one.

It might make a basis swap to adjust its cash flow, for example changing a six-month payment schedule for an annual one.

Finally, parties might make a basis swap to change the index for their interest income. While the LIBOR is a standard rate for floating interest rates in a swap, it is not the only index. A party might want to collect income based on the Federal Reserve's interest rate, for example, or it might seek payments indexed to a market. In this case it would exchange interest income based on the undesired index for income based on the desired metric.

Principle Correction

Very few parties will have underlying investments that match as perfectly as our example above. Instead, an interest rate swap is typically customized so that the underlying properties mimic each other in terms of principle, volume, maturity and any other relevant metric.

For example, in our case above, let's say Elizabeth held the note on a $1 million loan. In this case, she would enter into an interest rate swap for the first $500,000 of her loan to match the principle of Robert's investment.

The parties would swap interest income on the first $500,000 of Elizabeth's loan, and she would collect the interest income on the remaining half of her investment as normal.

Borrower Rate Swaps

Finally, it is also possible for borrowers to enter an interest rate swap.

Borrowers will do this for essentially the same reasons as investors, but from the opposite perspective. For example a borrower might swap a floating interest rate for a fixed one in order to seek greater certainty about their payments. Another might swap a fixed rate for a floating one in hopes of reducing their loan payments over time.

A borrower rate swap is structurally similar to an investor rate swap. The only difference is that the parties will make their interest payments as normal, and will afterward pay each other in order to balance out the difference in debt.