and it takes out a $1 million loan,

and it pays a variable interest rate on that loan.

It pays LIBOR plus 2%.

And LIBOR stands for London Interbank Offer Rate.

It's one of the major benchmarks for variable interest rates.

And so it pays that to some lender.

This is the person who lent company A the money.

It pays them a variable interest rate every period.

So for example, in period one if LIBOR is at 5%,

then in that period, company A will pay 7%, or $70,000

to the lender in that period.

In period two, if LIBOR goes, let's say

LIBOR goes down a little bit to 4%,

then company A is going to pay 4 plus 2, which is 6%,

which is $60,000 in interest.

Let's say that we have another company, company B,

right over here.

It also borrows $1 million, but it borrows it at a fixed rate.

Let's say it borrows it at a fixed rate of 8%.

So in each period, regardless of what

happens to LIBOR or any other benchmark-- so

this is to probably another lender, or different lender,

than the person that A borrowed it from.

And it could be a bank, or it might

be another company, or an investor of some kind.

We will call this Lender 1 and Lender 2.

So regardless of the period, right now

company B will pay 8% of $1 million

in each period, which is about $80,000,

or exactly $80,000, each period.

Now let's say that neither of these parties

are really happy with that situation.

Company A doesn't like the variability,

the unpredictability in what happens to LIBOR,

so they can't plan for how much they have to pay.

Company B feels like they're overpaying for interest.

They feel like, wow, the people who are doing variable interest

rates, they're paying a less amount of interest

every period.

And maybe they also, company B also,

thinks that interest rates are going to go down,

or that short term, or that variable rate

is going to go down, LIBOR is going to go down.

So that's an even bigger reason why

they want to become a variable rate borrower.

So what they can do, and neither of them

can get out of these lending agreements,

but what they can do is agree to essentially swap

some or all of their interest rate payments.

So for example, they can enter into an agreement,

and this would be called an interest rate swap, where

company A agrees to pay B-- maybe,

let's make up a number here-- 7% on a notional $1 million loan.

So, the $1 million will never change hands,

but company A agrees to pay B 7% of that notional $1 million,

or $70,000 per period.

And in return, company B agrees to pay A a variable rate.

Let's say it's LIBOR plus 1%, right over here.

And this little agreement-- and they

agreed they would agree to do this for some amount.

And once again, this is LIBOR plus 1%

on a notional $1 million.

And that word notional just means that $1 million

will never change hands, and they're just

going to exchange the interest payments on $1 million.

And this agreement right over here

is called an interest rate swap.

And I'll leave you there.

In the next video, we'll actually

go through the mechanics to see that A is truly now paying

a fixed rate when you put in all of their different payments

into both the swap and the lender,

and Company B, after entering into this swap agreement,

is now really paying a variable interest rate.