*The content of this article is excerpted from Chapter 3 "Swaps" of the OTC Derivatives Knowledge Reader.
Interest Rate Swap (IRS), also known as interest rate swap, refers to the trading behavior of the two parties agreeing to regularly exchange cash flows according to the agreed amount of nominal principal and interest rate within a certain period of time in the future, which is suitable for investors who need to manage interest rate risk.
In an interest rate swap transaction, the parties agree to exchange cash flows for a certain period of time in the future for the same notional principal in the same currency, with one party's cash flow calculated on the basis of a pre-selected floating rate and the other party's cash flow calculated on the basis of a fixed interest rate, and usually only the netting of the amount of interest payable by the parties to the transaction is paid, and no principal exchange occurs.
Figure 1 Structure of interest rate swap transactions
▍ Example of an interest rate swap
On March 1, 2023, Company A entered into a 5-year SOFR interest rate swap transaction with Company B, whereby Company A paid a variable rate SOFR at a fixed rate of 4.56%. Company A expects interest rates to fall in the future, and in order to avoid the risk of interest rate fluctuations, it carries out this transaction. The process of interest rate swap is as follows:
Figure 2 Schematic diagram of interest rate swaps
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