An interest rate swap (IRS) is an OTC derivative contract in which two parties periodically exchange interest payments of different types, on a specified notional principal, during a set period of time.
IRS are part of a family of financial products known as interest rate derivatives.
IRS (also known as plain vanilla swaps) are used to mitigate interest rate risk, specifically the risk that changes in future rates of interest will cause losses to be incurred.
Imagine that Firm X (a motor manufacturer) has an existing commitment to pay interest at a fixed rate of 4.0% for the next 5 years, to Party D, on a borrowing of EUR 30,000,000.00. Firm X chooses to compare that outgoing stream of fixed interest payments with an incoming stream of floating rate interest payments that are due from Party E, for the same cash amount and over the same 5-year period. Note: floating rate interest payments are representative of fluctuating money market interest rates. This situation is reflected in Figure 16.1, which is viewed from the perspective of Firm X: