What best describes an 'interest rate swap'?

An interest rate swap is best described as a financial contract involving the exchange of interest rate cash flows. This transaction typically occurs between two parties who agree to exchange interest payments on a specified principal amount, which is often referred to as the notional amount. While the principal is not exchanged, the parties swap cash flows based on fixed or floating interest rates over a defined period.

This arrangement allows entities to manage their interest rate exposure, aligning their interest rate profiles with their financial strategies or hedging requirements. For instance, one party may have a variable interest rate liability and wish to convert it into a fixed rate to stabilize future payments. Another party may prefer a floating rate to take advantage of expected lower interest rates. This swap provides flexibility in managing financial obligations without altering the underlying principal.

In contrast, the other available options do not accurately capture the essence of an interest rate swap. The first option refers to the exchange of principal amounts, which does not happen in a typical interest rate swap. The third option discusses currency risk hedging, which is more relevant to currency swaps rather than interest rate swaps. Lastly, a loan agreement between two corporations outlines borrowing terms rather than the exchange of interest payments. Thus, the description focusing on the exchange of interest rate cash flows