Interest rate swap 1 | Finance & Capital Markets | Khan Academy

Let's say that we've
got company A over here, and it takes out
a \$1 million loan, and it pays a variable
interest rate on that loan. It pays LIBOR plus 2%. And LIBOR stands for London
Interbank Offer Rate. It's one of the major benchmarks
for variable interest rates. And so it pays that
to some lender. This is the person who
lent company A the money. It pays them a variable
interest rate every period. So for example, in period
one if LIBOR is at 5%, then in that period, company
A will pay 7%, or \$70,000 to the lender in that period. In period two, if
LIBOR goes, let's say LIBOR goes down a
little bit to 4%, then company A is going to
pay 4 plus 2, which is 6%, which is \$60,000 in interest.

Let's say that we have
another company, company B, right over here. It also borrows \$1 million, but
it borrows it at a fixed rate. Let's say it borrows it
at a fixed rate of 8%. So in each period,
regardless of what happens to LIBOR or any
other benchmark– so this is to probably another
lender, or different lender, than the person that
A borrowed it from. And it could be a
bank, or it might be another company, or
an investor of some kind. We will call this
Lender 1 and Lender 2. So regardless of the
period, right now company B will pay
8% of \$1 million in each period, which
is about \$80,000, or exactly \$80,000, each period.

Now let's say that
neither of these parties are really happy
with that situation. Company A doesn't
like the variability, the unpredictability in
what happens to LIBOR, so they can't plan for
how much they have to pay. Company B feels like they're
overpaying for interest. They feel like, wow, the people
who are doing variable interest rates, they're paying a
less amount of interest every period. And maybe they also,
company B also, thinks that interest rates
are going to go down, or that short term,
or that variable rate is going to go down,
LIBOR is going to go down.

So that's an even
bigger reason why they want to become a
variable rate borrower. So what they can do,
and neither of them can get out of these
lending agreements, but what they can do is
agree to essentially swap some or all of their
interest rate payments. So for example, they can
enter into an agreement, and this would be called an
interest rate swap, where company A agrees
to pay B– maybe, let's make up a number here– 7%
on a notional \$1 million loan. So, the \$1 million will
never change hands, but company A agrees to pay B
7% of that notional \$1 million, or \$70,000 per period. And in return, company B agrees
to pay A a variable rate. Let's say it's LIBOR
plus 1%, right over here. And this little
agreement– and they agreed they would agree to
do this for some amount. And once again, this
is LIBOR plus 1% on a notional \$1 million. And that word notional
just means that \$1 million will never change
hands, and they're just going to exchange the interest
payments on \$1 million.

And this agreement
right over here is called an interest rate swap. And I'll leave you there. In the next video,
we'll actually go through the mechanics to
see that A is truly now paying a fixed rate when you put in
all of their different payments into both the swap
and the lender, and Company B, after entering
into this swap agreement, is now really paying a
variable interest rate..