It is a financial transaction in which two counterparties agree to exchange streams of cash flows throughout the life of contract in which one party pays a fixed interest rate on a notional principal and the other pays a floating rate on the same sum, popularly known as floating to fixed or fixed to floating IRS. IRS can also be floating to floating wherein either legs are floating.

The basic purpose of IRS is to hedge the interest rate risk of constituents and enable them to structure the asset/liability profile best suited to their respective cash flows.

When agreeing on an interest-rate swap, the bank and the customer trade variable and fixed rates. Under the interest rate swap the customer receives from the bank the variable rate of interest it owns under its loan(s) excluding any variable mark-ups, and subsequently pays a fixed rate as agreed under the interest rate swap to the bank. This set-up protects customer from increases in interest rates. Customer still has to pay any variable mark-ups and that these are not covered by interest-rate swaps.