Swaps are most used with interest rates. When two companies with loans have different views on where interest rates are going, they may decide to swap their rates with each other. The swap is often executed by using derivatives contracts. Swaps can be used on commodities, currencies, and debt-equity structures.
As an example, two companies have loans on $1 million but with different terms. Company A pays a variable rate (LIBOR) + 2% (lending margin). LIBOR is currently 3%, so Company A’s interest rate is effectively 5%. Company B is paying a fixed 5% rate. Both companies have the same rate. However, Company A believes interest rates are going to rise, which will increase its loan cost. Company B thinks rates are going to drop, which means it will miss out on savings. The two agree to swap interest rates on their loans. Company A saves if rates rise because its loan is now fixed. It’s just the opposite though if rates fall. The swap works in the opposite direction for Company B.
