Structure
In an interest rate swap, each counterparty agrees to pay either a fixed or floating rate denominated in a particular currency to the other counterparty. The fixed or floating rate is multiplied by a notional principal amount (say, USD 1 million) and an accrual factor given by the appropriate day count convention. When both legs are in the same currency, this notional amount is typically not exchanged between counterparties, but is used only for calculating the size of cashflows to be exchanged. When the legs are in different currencies, the respective notional amount are typically exchanged at the start and the end of the swap.
The most common interest rate swap is one where one counterparty A pays a fixed rate (the swap rate) to counterparty B, while receiving a floating rate indexed to a reference rate (such as LIBOR or EURIBOR). By market convention, the counterparty paying the fixed rate is called the "payer" (while receiving the floating rate), and the counterparty receiving the fixed rate is called the "receiver" (while paying the floating rate).
A pays fixed rate to B (A receives floating rate)
B pays floating rate to A (B receives fixed rate)
Currently, A borrows from Market @ LIBOR +1.5%. B borrows from Market @ 8.5%.
Consider the following swap in which Party A agrees to pay Party B periodic fixed interest rate payments of 8.65%, in exchange for periodic variable interest rate payments of LIBOR + 70 bps (0.70%) in the same currency. Note that there is no exchange of the principal amounts and that the interest rates are on a "notional" (i.e. imaginary) principal amount. Also note that the interest payments are settled in net (e.g. Party A pays (LIBOR + 1.50%)+8.65% - (LIBOR+0.70%) = 9.45% net). The fixed rate (8.65% in this example) is referred to as the swap rate.
At the point of initiation of the swap, the swap is priced so that it has a net present value of zero. If one party wants to pay 50 bps above the par swap rate, the other party has to pay approximately 50bps over LIBOR to compensate for this.
Read more about this topic: Interest Rate Swap
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