It is a contractual agreement to exchange a series of cash flows, in which one leg of cash flow is based on a fixed interest rate and the other leg is based on a floating rate. The cash flows are calculated and exchanged based on notional principal. There is no exchange of principal. 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.