What are interest rate swaps (IRS)?

IRS refers to the exchange of fixed-rate interest payments into floating-rate interest payments.

Contracts are generally based on an agreed principal amount, assumed to be $1,000,000. Delta has a current fixed interest rate of 1.5% per month, while Omega Investments has a floating rate-LIBOR-1% linked to the London Interbank Offered Rate.

Delta companies want to use high-risk floating rates, while Omega investment companies need to ensure that they have a safe and fixed amount of interest income every month. As a result, the parties entered into a swap agreement whereby Delta would pay Omega Investments at a principal of $1 million and a monthly interest rate of 1.5%, while the latter would pay Delta at a floating interest rate of LIBOR + 1%.

These are custom contracts (the terms are agreed between the two parties to the transaction) and are therefore not traded on an exchange. Similarly, it is difficult for retail investors to participate in IRS trading.

Who is the winner?

Such contracts are usually mutually beneficial, as one party must pay an agreed premium in order to receive an improvement in cash flow through the swap rate.