What is an interest rate swap?
Interest rate swaps are financial contracts between two parties where one party agrees to pay a fixed amount of interest in exchange for a floating-rate payment. An interest rate swap is a type of derivative that allows investors to hedge against changes in interest rates. It works by exchanging cash flows for a specified period of time at a specific interest rate.
Merriam Webster Online
Definition of swap: an act, instance, or process of exchanging one thing for another.
An interest rate swap’s (IRS’s) effective description is a derivative contract, agreed between two counterparties, which specifies the nature of an exchange of payments benchmarked against an interest rate index. The most common IRS is a fixed for floating swap, whereby one party will make payments to the other based on an initially agreed fixed rate of interest, to receive back payments based on a floating interest rate index. Each of these series of payments is termed a “leg”, so a typical IRS has both a fixed and a floating leg. The floating index is commonly an interbank offered rate (IBOR) of specific tenor in the appropriate currency of the IRS, for example LIBOR in GBP, EURIBOR in EUR, or STIBOR in SEK.
To completely determine any IRS a number of parameters must be specified for each leg:
- the notional principal amount (or varying notional schedule);
- the start and end dates, value-, trade- and settlement dates, and date scheduling (date rolling);
- the fixed rate (i.e. “swap rate”, sometimes quoted as a “swap spread” over a benchmark);
- the chosen floating interest rate index tenor
- the day count conventions for interest calculations.
Each currency has its own standard market conventions regarding the frequency of payments, the day count conventions and the end-of-month rule.