The example below details how two parties (A and B) enter an interest rate swap with the following specifications. For ease of understandings, swings in the Libor rate have been exagerated compared to normal market conditions.
Term: 10 yrs
Start date: Jan 2007
Payment dates: Semi-annual
Fixed: 5% (set as the 10 year swap rate on the yield curve on the start date)
Floating: 6 mth Libor
Party A has entered into an agreement to pay 5% of £100m throughout the investment on a semi-annual basis, i.e. £2,500,000 to party B.
Party B has promissed to pay whatever was the Libor rate at the start of the six-months period at each scheduled date of payment. In January 2007, if the Libor rate is 6%, this translates into a payment of £3 millions in July 2007 (6% p.a. of £100m divided by two for the semi-annual period). Note that the amount actually paid is the NET amount in this case a payment of £500,000 from B to A.
Similarly, in January 2008, if the Libor rate is 4%, this translates into a payment of £2,000,000 in July 2008. Here again only the net payment is transferred, i.e. £500,000 from A to B.