An interest rate swap is an agreement between two parties to exchange one stream of interest payments for another, over a set period of time. Swaps are derivative contracts and trade over-the-counter. The most commonly traded and most liquid interest rate swaps are known as “vanilla” swaps, which exchange fixed-rate payments for floating-rate payments based on LIBOR (London Inter-Bank Offered Rate). Although there are other types of interest rate swaps, such as those that trade one floating rate for another, vanilla swaps comprise the vast majority of the market.

Risks in interest rate swaps:
Interest rate swaps involve two primary risks: interest rate risk and credit risk, which is known in the swaps market as counterparty risk. Actual interest rate movements do not always match expectations. In a nutshell, a receiver (the counterparty receiving a fixed-rate payment stream) profits if interest rates fall and lose if interest rates rise. Conversely, the payer (the counterparty paying fixed) profits if rates rise and lose if rates fall.
These interest rate swaps are also subject to the counterparty risk or better known as credit risk. This is the risk that the other party in the contract will default on its responsibility. This is more so because most of these swap contracts are OTC contracts. This risk has been partially mitigated since the financial crisis as a large portion of swap contracts are now being cleared through central counterparties (CCPs). But, the risk still remains.