Interest Rate Swap

An interest rate swap is a contractual agreement between two counterparties to exchange cash flows on particular dates in the future. There are two types of legs (or series of cash flows). A fixed rate payer makes a series of fixed payments and at the outset of the swap, these cash flows are known. A floating rate payer makes a series of payments that depend on the future level of interest rates (a quoted index like LIBOR for example) and at the outset of the swap, most or all of these cash flows are not known. In general, a swap agreement stipulates all of the conditions and definitions required to administer the swap including the notional principal amount, fixed coupon, accrual methods, day count methods, effective date, terminating date, cash flow frequency, compounding frequency, and basis for the floating index.

An interest rate swap can either be fixed for floating (the most common), or floating for floating (often referred to as a basis swap). In brief, an interest rate swap is priced by first present valuing each leg of the swap (using the appropriate interest rate curve) and then aggregating the two results.