An interest rate swap is a derivative contract between two parties to swap or exchange cashflows representing two separate streams of interest payments, denominated in a single currency and calculated on a ‘notional’ principal amount.
Interest rate swaps can help institutions manage the risks associated with volatility in interest rates. They also provide fixed income traders an opportunity to speculate on the movement in interest rates.
Interest rate swaps come in two forms: Fixed to Floating Swaps and Floating to Floating Rate Swaps.
In a fixed to floating interest rate swap, one counterparty receives a fixed rate of interest payment on a notional principal amount and simultaneously pays out at a floating rate of interest. Typically, the floating interest rate is linked to an external benchmark rate like the LIBOR.
In a floating-to-floating swap, two parties trade cashflows representing interest payments on a ‘notional’ principle amount based on floating interest rates that is linked to two separate benchmarks.
Interest rate swaps are over-the-counter financial instruments and involve significant counterparty risk.