Interest Rate Swap

Trade fixed for floating payments

The workhorse of the OTC market. Two parties agree to exchange interest payments on an agreed notional amount — one leg fixed, the other floating — for an agreed term. Nothing is lent and nothing is borrowed; the swap simply changes the character of interest a party pays or receives, which is why a borrower with a floating loan can end up with the economics of a fixed one without renegotiating the loan.

Open in the app · Interest Rate · foundational

The lesson

1. What it is

Two parties exchange interest payments on a notional principal — one pays a fixed rate, the other a floating rate (e.g. SOFR). The notional itself is never exchanged, only the interest.

The interest rate swap market is the largest OTC derivatives market in the world, with hundreds of trillions of dollars in notional outstanding.

2. How it works

Each period has a floating rate that settles against the benchmark, and on each payment date the two legs are netted so only the difference changes hands. On a $100m swap paying 4% fixed against a floating leg that sets at 4.5%, the fixed payer receives 0.5% on the notional for that period.

The reset fixes which rate applies to a period, but an overnight benchmark such as SOFR is compounded across that period, so the rate itself is only known once the period has run. Payment then follows a few business days later.

3. Why it’s used

Firms use swaps to convert floating-rate debt into fixed (or vice versa), hedging against rate moves, or to speculate on the direction of rates without borrowing directly. A treasurer who has borrowed floating but wants budget certainty pays fixed on a swap and keeps receiving floating, which offsets the loan.

4. Key terms

Notional, fixed rate, floating reference rate, tenor, and payment/reset frequency define every swap contract. The effective date sets when interest starts accruing, and the day count convention determines exactly how each payment is calculated.

Day count matters more than it looks: 30/360 and ACT/360 on the same rate and notional produce different cash.

5. Risks to watch

The swap only hedges what it matches — a mismatch in dates or amounts leaves residual exposure. Value moves with rates, so an off-market swap creates mark-to-market swings and collateral calls, and each party carries credit risk on the other unless the trade is centrally cleared.

A treasurer fixes a floating loan

A company has borrowed $200m at SOFR + 1%, paid annually.
It enters a 5-year swap: it pays 3% fixed and receives SOFR on the same $200m.
In year one SOFR sets at 3.8%, so the loan costs 4.8% — $9.6m.
On the swap it pays $6m fixed and receives $7.6m floating, a net receipt of $1.6m.
Total cash out is $9.6m − $1.6m = $8m, which is 4% of $200m.

Whatever SOFR does, the company pays 4% — the fixed swap rate plus its 1% credit spread. The floating leg of the swap cancels the floating cost of the loan.

Key terms

Notional — The reference amount interest is calculated on. It is never exchanged in a standard swap.
Fixed leg — The side paying a rate agreed at inception that does not change for the life of the trade.
Floating leg — The side paying a rate that resets periodically against a published benchmark such as SOFR.
Reset date — The date that starts a new calculation period and fixes which benchmark rate applies to it.
Tenor — The total life of the swap, from effective date to maturity — commonly 2, 5 or 10 years.
Day count convention — The rule converting an annual rate into the fraction actually owed for a period, such as ACT/360.

In practice

Corporate treasurers use these to turn a floating bank loan into a predictable budget line, and pension funds use long-dated swaps to match the fixed liabilities they owe retirees. Most standardised swaps now clear through a central counterparty rather than settling bilaterally.

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