Interest Rate Swap [IRS]

An Interest Rate Swap (IRS) is a derivative contract where two parties exchange interest payment streams on a notional principal amount, typically swapping fixed-rate payments for floating-rate payments. For example, Company A might pay fixed 3% annually while receiving floating SOFR + 50 basis points quarterly on $100 million notional for five years. No principal changes hands, only net interest differences. Companies use swaps to hedge interest rate risk or convert debt from fixed to floating (or vice versa) without refinancing. A firm with floating-rate debt might enter a pay-fixed swap to lock in rates. The swap market exceeds $400 trillion in notional outstanding, dwarfing bond markets. Swap rates serve as key benchmarks, with the swap curve often replacing government curves for pricing. Most swaps are now centrally cleared through clearinghouses like LCH or CME, with daily margin requirements. Valuation involves discounting future cash flows using forward curves. Banks act as dealers, earning bid-ask spreads while hedging their books. Swaps enable efficient risk transfer and arbitrage between markets.