What is an interest rate swap, and how does it function as a financial instrument?

An interest rate swap is a financial derivative that companies use to exchange interest rate payments with each other.

Swaps are useful when one company wants to receive a payment with a variable interest rate, while the other wants to limit future risk by receiving a fixed-rate payment instead.

Here's how it works:

1. Two parties, known as counterparties, agree to exchange payments on an agreed-upon amount of principal, known as the notional principal amount. This amount is theoretical and does not actually change hands.

2. For a set period of time, the two counterparties swap interest payments on the notional principal amount. One party pays interest at a fixed rate, and the other pays interest at a floating rate. The floating rate is usually tied to a reference rate such as LIBOR.

3. The interest payments are netted against each other, with the difference being paid by the party who owes more to the party who is owed.

4. At the end of the swap agreement, the principal does not change hands again. It is a purely financial transaction.

Interest rate swaps are a type of over-the-counter derivative. This means they are privately negotiated and are not traded on an exchange. They are used by businesses, investors, and financial institutions to manage risk and speculate on future interest rate movements.