Interest Rate Swap (IRS), what it is, how it works and examples

Interest rate swaps are one of the most significant instruments in the modern financial market, with a trading volume that testifies to their fundamental importance in managing financial risk. First, it is important to understand that they are contracts in which two parties exchange interest payments based on a specified notional amount, typically involving a fixed-to-floating rate swap.

In fact, with the recent transition from LIBOR to the Secured Overnight Financing Rate (SOFR) as a benchmark, these instruments have taken on an even more crucial role. The flexibility of these contracts, with maturities ranging from one to fifteen years, offers various opportunities for managing interest rate risk.

In this practical guide, we will explore together how interest rate swaps work, the essential calculation formulas and strategies to effectively evaluate and manage the associated risks.

What is an Interest Rate Swap, definition and meaning

Let’s immediately give a practical and precise definition of the instrument:

the Interest Rate Swap (IRS) represents a derivative financial contract through which two counterparties undertake to exchange flows of interest payments, calculated on a predefined notional capital. In particular, this financial instrument allows the exchange of cash flows based on different interest rates, usually one fixed and the other variable.

The structure of the IRS is based on well-defined fundamental elements. First of all, the notional capital, which is never actually exchanged between the parties, serves exclusively as the basis for the calculation of interest. Furthermore, the contract establishes:

• the date of stipulation (trade date);
• the start date (effective date);
• the expiration date (termination date);
• the payment dates (payment dates);
• the indexing parameters for calculating the rates.

How the Interest Rate Swap Works

In the IRS market, the parties assume specific and complementary rolesi. The buyer of the IRS, called the "fixed rate payer", undertakes to pay the fixed rate and receives the floating rate. On the other hand, the seller, called the "floating rate payer", collects the fixed rate and pays the floating rate.

The negotiation typically takes place in the over the counter (OTC) market, where at least one of the parties must necessarily be an authorized intermediary, such as a bank or an investment company. This requirement ensures that the contract is structured according to professional and regulated parameters.

The intermediary plays a crucial role because it creates the financial instrument and knows all the elements that qualify its risk, being able to contain or eliminate the risk in the context of similar contracts stipulated with its customers.

Interest Rate Swap, how is it calculated?

In the operating mechanism of the IRS, the calculation of financial flows follows a well-defined structure. Payments are determined by applying different interest rates to a pre-established notional capital, which serves exclusively to calculate the amount of the flows.

Calculation of the fixed rate

• The fixed rate is calculated according to the formula: Eurirs Rate + Spread, where the Eurirs corresponds to the duration of the repayment plan. This value remains constant for the entire duration of the contract, ensuring stability in periodic payments.

Determination of the variable value

• The variable flow is calculated by applying the Euribor, usually at 3 or 6 months, plus a possible spread. The determination is made by fixing the rate two working days before the start of each calculation period.

Practical example of step-by-step calculation

Let’s consider an IRS with the following characteristics:

• Notional capital: € 2,000,000
• Duration: 3 years
• Fixed rate: 4.30%
• Variable rate: Euribor 3 months

The differential is calculated as: ((TV-TF)/100) × CN × (GG/360)

Where:

• TV = Variable Rate
• TF = Fixed Rate
• CN = Notional Capital
• GG = Actual days of the period

Original article published on Money.it Italy. Original title: Interest Rate Swap (IRS), cos’è, come funziona ed esempi