An interest rate swap is a simple exchange of interest payments. It can be used to minimize interest the risk posed by changing interest rates or to benefit from changing interest rates.
Frequently, these swaps involve the exchange of fixed rate and variable rate mortgages. This type of transaction is often referred to as a plain vanilla swap.
To keep things simple, only the differences in rates on previously agreed to dates are exchanged (known as «netting»), rather than swapping all interest rate amounts.
As a rule, an entity that is obligated to pay a fixed interest rate, but swaps this for a variable rate, is referred to as the «payer». Likewise, this swap is called a «payer swap».
An entity that exchanges their variable rate for a fixed rate is referred to as the «receiver». This swap is known as a «receiver swap».
Entity A took out a 1 million franc loan with a fixed interest rate of 3% per annum and a 10-year tenure.
Entity B also borrowed 1 million francs on a 10 year loan tenure, only with a variable interest rate. The variable interest rate follows a guide index, such as the LIBOR, but includes a markup on index rates.
Lets say that entity B currently has a 3% annual interest rate and wants to secure this rate against a possible rate hike because he worries that rates may rise. Entity A, on the other hand, expects the index to drop, which would leave him at a disadvantage due to his 3% fixed interest rate.
Solution: A and B agree to swap interest rates for a predetermined time span. If the variable rates which B should have paid climb to 3.5%, B wins because they only have to pay A’s 3% fixed rate. A would be the obvious loser in this scenario, because they would have to pay the 3.5% variable rate that they took on from B. In this case A would pay the 0.5% difference to B.