Interest rate swap

A swap is an agreement between two counterparties to exchange something (one
"leg" of the swap) for something else (the other "leg"). These things can be
anything that has a financial value. Typically they are quantities
determined by some form of interest rate, in an interest rate swap or derivative.

Interest rate swaps take many forms. Typically they consist of a number of
component swaps on a frequent basis according to a predetermined payment schedule.

Usually, one leg involves quantities that are known in advance, known as the
"fixed leg", the other involves quantities that are not known in advance,
known as the "floating leg". The floating leg must therefore be reset
against an agreed "reference rate", which will become known at some point
before the payment or settlement takes place. Ideally, the determination of
the reference rate must be outside the control of the counterparties,
otherwise a conflict of interest will arise. However, many financial
products in the retail market (such as capped mortgages) involve reference
to a managed interest rate which is actually controlled by the mortgage
provider. Typically, the reference rate is some figure made publicly
available by a third party information vendor, or by government agencies.
For example, BBA LIBOR.

Once a component of the floating leg is fixed (or "reset"), the fixed and
floating components can be swapped or settlement (typically one or two days
after the fixing date).

The present value of a vanilla swap can easily be computed using standard
methods of determining the present value of the components.

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