What is an interest rate swap?

An interest rate swap is fundamentally a contract between two parties to exchange cash flows based on different interest rates, which aligns perfectly with the provided answer. In a typical interest rate swap, one party pays a fixed interest rate while receiving a variable interest rate, or vice versa. This arrangement allows parties to manage their exposure to fluctuations in interest rates, hedging against potential increases or decreases.

The significance of the interest rate swap lies in its utility for managing interest rate risk and customizing cash flow preferences to suit each party’s financial strategy. Organizations often use these swaps to align their debt obligations with their revenue streams, thereby gaining more favorable financial outcomes.

In a broader context, interest rate swaps are crucial tools in fixed income markets, enabling participants to effectively manage risk and enhance liquidity without necessarily changing the underlying debt instruments.