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Interest Rate Swap
An agreement between two parties to exchange a series of interest payments based on an agreed principal amount (often termed the "notional" amount). Because the parties exchange only the interest payments without exchanging the underlying debt, interest rate swaps do not appear on the balance sheets of the participants, although the inflows and outflows from swap transactions show up on the income statement.
Early interest rate swaps became popular in the Euromarkets starting around 1981. The typical swap transaction involved a firm with a high credit rating with a desire for short-term funds and a lower-rated company needing longer-term fixed-rate funds. The better-rated company normally had a comparative advantage in raising longer-term funds because investors tend to require a higher-risk premium for securities with longer maturities. The major risk to either party in the transaction is that the other will default.
The largest market for interest rate swaps is denominated in U.S. dollars. Many swaps are now arranged through commercial or investment banks acting as intermediaries for a fee.
The size of the market in swaps has grown dramatically from an estimated $3 billion in 1982 to more than $200 billion by 1986. It is reported that over 50% of the volume of new Eurobond issues is now swap related. It has become common for companies to use the swap market to transform floating-rate debt into fixed-rate obligations, especially for savings and loans associations that traditionally have substantial gaps between the duration of their assets and that of their liabilities. Other companies are able to use swaps to "unlock" high coupon debt by swapping it for lower variable-rate debt.
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