An interest rate derivative is a derivative where the underlying asset is the right to pay or receive a notional amount of money at a given interest rate. Interest rate swaps are over-the-counter instruments. In an interest rate swap, two parties agree to “swap,” or exchange, periodic interest payments. The amount of the interest payments exchanged is based on some predetermined principal also known as the notional principal.
The notional principal for the swap can vary over the life of the swap. A swap in which the notional principal decreases over time is called an amortizing swap. A swap in which the notional principal increases over time is called an accreting swap. Swaps where both parties pay a floating interest rate is referred to as a basis swap.
Being a derivative instrument, an interest rate swap per se qualifies as a hedging instrument. It should be noted that in an interest rate swap the risk reward is symmetric and can be more or less compared to an equity futures position. An interest rate swap instrument can be used to hedge primarily interest rate risk.
This type of interest rate swap instrument can be used for conversion of fixed rate debt into variable rate debt, and fair value hedge accounting is applicable for this case subject to the fulfillment of all other requirements for hedge accounting.
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