An interest rate swap (IRS) is an agreement between two parties to exchange interest payments on a defined notional amount over a specified period. One party pays a fixed rate; the other pays a floating rate tied to a benchmark such as SONIA (Sterling Overnight Index Average). No principal changes hands — only the net interest payments.
Why firms use interest rate swaps
The most common motivation is managing the mismatch between how a firm borrows and what it actually wants to pay. A company that has issued a fixed-rate bond but believes rates will fall can enter a swap to receive fixed and pay floating — converting its effective exposure without touching the underlying debt. A bank that funds itself at floating rates but lends at fixed rates uses swaps to align its interest income and funding cost. Pension funds use long-dated swaps to match the duration of their liabilities.
Who uses them
Banks, pension funds, insurance companies, corporates, and asset managers all use IRS for different reasons. The market is enormous — hundreds of trillions of notional outstanding globally. The vast majority of vanilla IRS are now centrally cleared through LCH SwapClear, which stands between the two counterparties and manages default risk.
What determines the fixed rate
The fixed rate on a swap — the 'par swap rate' — is set at inception so that the swap has zero value to both parties at the outset. It is derived from the yield curve: specifically, from the rates on liquid instruments across maturities. A five-year par swap rate represents the market's collective expectation of where floating rates will average over the next five years, discounted appropriately.