Interest rate swaps

An interest rate swap (IRS) is a liquid financial derivative instrument in which two parties agree to exchange interest rate cash flows, based on a specified notional amount from a fixed rate to a floating rate (or vice versa) or from one floating rate to another. Interest rate swaps can be used for both hedging and speculating.

In an interest rate swap, each counterparty agrees to pay either a fixed or floating rate denominated in a particular currency to the other counterparty. The fixed or floating rate is multiplied by a notional principal amount (say, $1 million) and an accrual factor given by the appropriate day count convention. When both legs are in the same currency, this notional amount is typically not exchanged between counterparties, but is used only for calculating the size of cashflows to be exchanged. When the legs are in different currencies, the respective notional amounts are typically exchanged at the start and the end of the swap, which is called cross currency interest rate swap.

The most common interest rate swap involves counterparty A paying a fixed rate (the swap rate) to counterparty B while receiving a floating rate indexed to a reference rate like LIBOR, EURIBOR, or MIBOR. By market convention, the counterparty paying the fixed rate is the "payer" (while receiving the floating rate), and the counterparty receiving the fixed rate is the "receiver" (while paying the floating rate).

A pays fixed rate to B (A receives floating rate)

B pays floating rate to A (B receives fixed rate)

Currently, A borrows from Market @ LIBOR +1.5%. B borrows from Market @ 8.5%.

Consider the following swap in which Party A agrees to pay Party B periodic fixed interest rate payments of 8.65% in exchange for periodic variable interest rate payments of LIBOR + 70 bps (0.70%) in the same currency. Note that there is no exchange of the principal amounts and that the interest rates are on a "notional" (i.e., imaginary) principal amount. Also note that interest payments are settled in net; that is, Party A pays (LIBOR + 1.50%)+8.65% - (LIBOR+0.70%) = 9.45% net. The fixed rate (8.65% in this example) is referred to as the swap rate.

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