A swap that allows investors to change the nature of their liabilities. It involves the exchange of payments on one liability (debt) for payments on another. One counterparty can exchange a stream of cash outflows for a liability (say, a loan) into another different stream of outflows. Through a liability swap, the investor can transform a fixed-rate liability into a floating-rate liability by taking on the role of the floating-rate payment in an interest rate swap.
For example, a bank may enter into an interest rate swap in which it pays LIBOR+ 40 basis points and receives 7% (annual rate). The bank, thus, uses the loan capital to purchase a floating rate bond so that the floating rate coupons received can be used to cover the floating rate interest payments under the interest rate swap. If the floating rate coupon rate exceeds LIBOR +40 basis points, the bank is said to be locking in a positive spread on funding costs.
As an interest rate swap, this swap involves the exchange of a stream of payments at a given interest rate for a stream of payments at another interest rate, over a specific period of time (2, 3,.., 10 years). In the context of currency swaps, most commonly a currency swap is, by default, presumed to be a liability swap. Otherwise, a currency swap is an asset swap. The structures of a liability swap and an asset swap are identical. However, the purpose of the swap is typically what dictates the naming.
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