Interest Rate Swap
Interest rate swaps are sometimes called as plain vanilla swaps.
Interest rate swap is an agreement between two parties to exchange one stream of interest payments for another over a specified period of time. It is not traded on public exchanges but only through over the counter (OTC).
They can exchange fixed or floating rates to reduce or increase exposure to fluctuations in interest rates.
In an interest rate swap, the principal amount is not exchanged between the counterparties, but interest payments are exchanged based on notional principles.
Interest rate swaps are sometimes called as plain vanilla swaps.
Fixed and floating interest rates
A fixed interest rate is an interest rate on a debt or other security that remains unchanged during the entire term of the contract, or until the maturity of the security. In contrast, floating interest rates fluctuate over time, with the changes in interest rate usually based on an underlying benchmark index. Floating interest rate bonds are frequently used in interest rate swaps, with the bond’s interest rate based on the London Interbank Offered Rate (LIBOR). Briefly, the LIBOR rate is an average interest rate that the leading banks participating in the London interbank market charge each other for short-term loans.
The LIBOR rate is a commonly used benchmark for determining other interest rates that lenders charge for various types of financing.