What type of swap involves parties exchanging cash flows based on interest rate risks?

The correct answer is interest rate swap. This type of swap specifically involves two parties agreeing to exchange cash flows that are tied to interest rates. Typically, one party will pay a fixed interest rate, while the other will pay a floating interest rate, which is usually adjusted based on a benchmark rate. This format allows organizations to manage their exposure to interest rate fluctuations, making it easier to align their cash flows with their financial strategies or investment needs.

Interest rate swaps are often used by companies to hedge against interest rate risk, particularly if they have outstanding debt. By entering into a swap agreement, they can potentially lower their borrowing costs or stabilize their interest expenses. Overall, this financial instrument plays a crucial role in risk management for entities dealing with variable interest rates.

In contrast, other types of swaps serve different functions. A currency swap involves exchanging cash flows in different currencies and is focused on hedging currency risk. A credit swap deals with transferring credit risk associated with an underlying asset or default risk. Lastly, a commodity swap is centered around exchanging cash flows related to the prices of physical goods or commodities. Each type of swap addresses specific financial risks but an interest rate swap is distinctly geared toward managing interest rate risks.