Interest Rate Swap
A swap in which one party pays a fixed interest rate and receives a floating rate on a notional principal.
What is Interest Rate Swap?
An interest rate swap (IRS) is the most common type of swap contract. In its plain-vanilla form, one counterparty agrees to pay a fixed interest rate while receiving a floating rate — typically SOFR (Secured Overnight Financing Rate) — on the same notional principal amount over an agreed term. No principal is exchanged; only the net difference in interest payments changes hands on each settlement date. Corporations use interest rate swaps to convert floating-rate debt to fixed, gaining cash flow certainty. Banks use them to manage the duration mismatch between their assets (long-term fixed-rate loans) and liabilities (short-term deposits). Interest rate swaps are the largest segment of the global OTC derivatives market by notional outstanding.
Example
A manufacturer has a $200 million floating-rate term loan priced at SOFR + 150 bps. Concerned that rates will rise, the CFO enters a five-year interest rate swap, paying 5.25% fixed to a bank and receiving SOFR + 150 bps. The floating leg of the swap offsets the loan's floating cost, leaving the company with an effective fixed all-in rate of 5.25%.
Source: ISDA — Interest Rate Derivatives