Interest Rate Swap (IRS)

What is an Interest Rate Swap?

An interest rate swap (IRS) is a type of derivative contract through which two counterparties agree to exchange one stream of future interest payments for another, based on a specified principal amount. In most cases, interest rate swaps include the exchange of a fixed interest rate for a floating rate.

Similar to other types of swaps, interest rate swaps are not traded on public exchanges — only over-the-counter (OTC).

Fixed Interest Rate vs. Floating Interest Rate

Interest rate swaps usually involve the exchange of one stream of future payments based on a fixed interest rate for another stream of payments based on a floating interest rate. To understand how these swaps work, it’s important to understand the difference between fixed-rate and floating-rate interest payments.

A fixed interest rate is an interest rate on a loan or security that remains the same throughout the entire term of the agreement. This provides predictability and stability in interest payments, which is helpful for budgeting and risk management.

In contrast, a floating interest rate changes over time. It’s typically tied to a market-based benchmark rate that reflects short-term borrowing costs in the economy. Today, the most widely used benchmark in U.S. dollar interest rate swaps is the Secured Overnight Financing Rate (SOFR). SOFR is based on actual transactions in the U.S. Treasury repurchase market, making it a more transparent and reliable benchmark than LIBOR, which was phased out in 2023.

Other countries have adopted their own benchmark rates:

• The UK uses SONIA (Sterling Overnight Index Average).
• The Eurozone uses €STR (Euro Short-Term Rate).
• Switzerland uses SARON (Swiss Average Rate Overnight).
• Japan uses TONA (Tokyo Overnight Average Rate).

Floating-rate legs in swap contracts are now typically based on these alternative reference rates (ARRs). These rates are usually overnight rates, and interest payments are often calculated using a compounded average of the daily rates over the payment period. 

Note: Unlike LIBOR, which was a forward-looking term rate, the current benchmarks are backward-looking and usually paid in arrears, based on the actual rates that prevailed during the accrual period.

By exchanging fixed for floating interest payments, or vice versa, each party in the swap can better manage its exposure to changing interest rates — whether the goal is to lock in stability or gain from potential rate shifts.

How Does an Interest Rate Swap Work?

An interest rate swap occurs when two parties — one receiving fixed-rate interest payments and the other receiving floating-rate payments — agree to exchange their interest obligations. In practice, this means:

• One party pays a fixed rate and receives a floating rate.
• The other party pays a floating rate and receives a fixed rate.

The underlying loans or bonds are not exchanged. Instead, the swap is a contract to exchange only the net difference in interest payments, based on a notional principal amount that is never actually exchanged. On each settlement date, one party makes a net payment to the other, depending on how the agreed rates compare.

A well-structured interest rate swap clearly outlines all terms: the fixed and floating rates, the notional amount, the payment frequency (e.g., quarterly or annually), and the start and end dates of the agreement.

Note: The floating leg is typically based on an overnight risk-free rate such as SOFR, and payments are calculated and settled using methods discussed earlier. These structural changes reflect the shift away from LIBOR to more transparent, transaction-based benchmarks.

While both parties enter the swap to meet specific goals, such as locking in payment stability or gaining exposure to rate movements, only one side ultimately benefits, depending on how interest rates evolve during the life of the contract. If rates rise, the floating-rate receiver gains. If rates fall, the fixed-rate receiver comes out ahead.

Example: An Interest Rate Swap Contract in Action

Let’s look at an example of how an interest rate swap works in practice.

Two companies, A and B, agree to enter into a fixed-for-floating interest rate swap with a notional value of $100,000 and a term of two years. Company A believes interest rates are likely to rise and wants to benefit from floating-rate payments. Company B, on the other hand, is concerned about potential rate declines and prefers the stability of a fixed rate.

They agree to the following terms:

• Company A pays a fixed rate of 5% annually to Company B.
• Company B pays a floating rate based on the compounded SOFR rate to Company A.
• Company A receives floating, pays fixed; Company B receives fixed, pays floating
• Payments are made once per year, based on a notional principal of $100,000.

Note: In real-world contracts, the floating leg is calculated as a compounded average of daily SOFR values over the accrual period. Payments are settled in arrears. For simplicity, we’ll use rounded annualized SOFR values in this example.

Year 1

Suppose the compounded SOFR rate for the first year is 4.00%.

• Company A owes Company B: 5% × $100,000 = $5,000
• Company B owes Company A: 4% × $100,000 = $4,000
• Net payment: Company A pays $1,000 to Company B

In this case, the fixed-rate payer (Company A) incurs a net loss, while the floating-rate payer (Company B) benefits from the lower rate environment.

Year 2 (rising rates)

Now, assume that interest rates increase, and the compounded SOFR rate for the second year is 5.25%.

• Company A owes Company B: $5,000
• Company B owes Company A: 5.25% × $100,000 = $5,250
• Net payment: Company B pays $250 to Company A

This time, Company A benefits from rising rates and receives a net payment, while Company B pays more than it receives.

Alternate Year 2 (falling rates)

What if SOFR had declined instead? Suppose the compounded SOFR rate falls to 3.75%.

• Company A owes Company B: $5,000
• Company B owes Company A: 3.75% × $100,000 = $3,750
• Net payment: Company A pays $1,250 to Company B

Here, Company B is protected from declining interest rates by locking in the fixed 5%, while Company A bears the downside of receiving a lower floating payment.

This example illustrates how each party’s risk profile changes depending on the direction of interest rates. The swap structure allows one party to hedge against rate volatility, while the other gains exposure to rate movements without exchanging the underlying debt.

Risks of Interest Rate Swaps

Interest rate swaps are an effective type of derivative that may benefit both parties in various ways.  However, swap agreements also come with risks.

One notable risk is counterparty risk. Because the parties involved are typically large companies or financial institutions, counterparty risk is usually relatively low. But if one of the two parties defaults and is unable to meet its obligations under the interest rate swap agreement, then it would be difficult for the other party to collect. It would have an enforceable contract, but following the legal process might well be a long and twisting road.

To reduce this risk, many interest rate swaps, especially those between financial institutions, are now cleared through central counterparties (CCPs). These clearinghouses act as intermediaries between the parties. They assume counterparty risk and help ensure that swap obligations are met even if one party defaults.

The unpredictability of floating interest rates introduces additional risk, especially for the party receiving variable payments tied to market benchmarks like SOFR. 

Additional Resources

Thank you for reading CFI’s guide on Interest Rate Swap. To learn more and advance your career, see the following free CFI resources:

• Interest Payable
• Forward Rates Models
• Quanto Swap
• Debt-to-Equity Ratio
• CDS Payout Ratio
• See all derivatives resources