What is an interest rate swap?

An interest rate swap is fundamentally a financial agreement in which two parties exchange cash flows based on different interest rate structures. Typically, one party pays a fixed interest rate while receiving a variable interest rate, and the other party does the opposite. This arrangement allows parties to manage their interest rate risk, optimize their financing costs, or adjust the interest rate exposure of their liabilities or assets without needing to restructure their underlying debt or investment portfolios.

In the context of the other options, a loan exchange between banks refers to lending activities and does not capture the specific nature of interest rate payments being swapped. Bond insurance is related to protecting bondholders against default, rather than dealing with the exchange of interest payments. An investment strategy aimed at reducing interest payments might involve various tactics but does not specifically define the mechanism of cash flow exchanges inherent in interest rate swaps. Thus, the best and most accurate description of an interest rate swap is the one focused on the transaction involving the exchange of interest rate cash flows.