You have a loan on a fixed annual interest rate of 7% over five years. Tom has a similar loan, over the same period, but on a floating interest rate. You and Tom are thinking to take over each other's obligations, so that you pay the floating interest rate and Tom pays the fixed rate. What kind of deal is this?
A)An option.
B)A forward contract.
C)A swap contract.
D)A futures contract.

Question

Quizplus · Accepted Answer

This deal is a swap contract. A swap is a contract by which two parties exchange the cash flow linked to an asset.
Key Takeaway: If you and Tom live in separate countries that have comparative advantages on interest rates, then a swap could benefit both of you. If you have a lower fixed interest rate, while Tom has access to a lower floating interest rate, then you two could swap to take advantage of the lower rates.

You Have a Loan on a Fixed Annual Interest Rate