What are interest rate swaps (IRS)?
This is where one stream of fixed-rate interest payments is exchanged for a floating rate stream of interest payments.
The contract is based on an agreed principal amount – let's say $1 million. Delta Corp is currently receiving a fixed rate of 1.5 per cent interest per month on its principal amount, while Omega Investments receives a floating rate that is tied to the London Interbank Offered Rate – LIBOR + 1 per cent.
Delta Corp decides it wants to take a higher risk on a floating rate, and Omega Investments needs to lock in a secure monthly payment that doesn't change – so the two parties enter into swap agreement where Delta Corp pays Omega 1.5 per cent interest a month on the $1 million principal amount, and Omega pays Delta Corp LIBOR + 1 per cent.
These are customised contracts – the specifications are agreed between the counterparties – and are therefore not traded on exchanges. Again, it is very difficult for retail investors to gain access to IRS.
There are often mutual benefits, as one side must pay an agreed premium to gain a better cash flow from a swapped rate.
Are interest rate swaps traded on exchanges?