An interest rate swap (specifically an amortizing fixed-for-floating rate swap) in which the fixed rate is set above the market rate for a constant notional principal swap, and the amortization rate is inversely related to interest rate. The notional principal changes according to an index or reference rate. As interest rates increase, the notional amount decreases and vice versa. At each reset date, the notional is decreased according to the fixing of the floating rate. The lower the interest rates, the greater the decrease in notional principal.

This swap has an embedded option that allows the holder to receive payment if interest rates fall below a prespecified level. In this sense, the holder can benefit from the fall in interest rates, and consequently offset the swap’s reduced value in case interest rates decrease. This type of swaps, which also known as an index amortizing swap, is mainly used to hedge a pool of mortgages (especially against prepayment risk), where the reduction in principal corresponds to anticipated prepayment.

The indexed principal swap is also called a LIBOR indexed principal swap (LIPS).