What is an interest rate swap?

An interest rate swap is best described as a financial contract in which two parties exchange cash flows based on a specified notional amount. In a typical interest rate swap, one party pays a fixed interest rate while receiving a floating interest rate from the other party, or vice versa. The notional amount is not exchanged; instead, it serves as a reference for calculating the cash flows carried out between the parties. This arrangement allows institutions to manage their interest rate exposure effectively, whether for speculating on interest rate movements or for hedging purposes.

The other choices do not adequately capture the essence of an interest rate swap. The first option refers to the exchange of market indices, which does not align with the mechanics of interest rate swaps, as these contracts involve specific cash flows rather than entire indices. The third option relates to currency exchange rates, which is irrelevant to the definition and purpose of an interest rate swap, as it pertains specifically to cash flows resulting from interest rates on debt instruments. Lastly, while spreading risk is an important aspect in finance, describing it as a method in the context of an interest rate swap is overly broad and does not directly define what an interest rate swap actually is. Thus, option B precisely characterizes the nature of interest rate swaps in