Interest Rate Swap

Key takeaways

• An interest rate swap is a contract in which two parties exchange streams of interest payments tied to a specified notional principal.
• The most common form swaps fixed-rate payments for floating-rate payments (or vice versa); basis swaps exchange one floating index for another.
• Swaps are over-the-counter (OTC) and highly customizable to match maturities, payment dates, and reference rates.
• Benchmark reference rates have shifted from LIBOR to alternatives such as SOFR.

What it is

An interest rate swap is a derivative agreement that lets two counterparties exchange future interest payment obligations without exchanging the underlying principal. One party typically pays a fixed rate while receiving a floating rate linked to a benchmark index; the other party does the opposite. The contract is priced and settled on a notional principal amount, which is never exchanged.

How it works

• Parties agree on notional amount, tenor, payment frequency, fixed rate, floating-rate index (e.g., SOFR), and any spread.
• On each payment date, the two legs are netted so only the difference is paid by the party that owes more.
• Because swaps are OTC, terms can be tailored to mirror an existing loan or bond, enabling effective hedging of interest-rate exposure.

Common types

• Fixed-for-floating (vanilla swap): One side pays a fixed rate and receives a floating rate. Used by borrowers who prefer fixed payments while funding sources are floating, or vice versa.
• Floating-for-fixed: Mirror image of the vanilla swap — a party receiving a fixed rate but paying floating. Often used to convert floating-rate debt into synthetic fixed-rate debt.
• Floating-for-floating (basis swap): Two parties exchange floating payments tied to different reference indices or tenors (e.g., 3‑month SOFR versus 6‑month SOFR) to better match cash flows or take advantage of relative rate movements.

Reference rates

Markets have transitioned away from LIBOR toward alternative benchmarks (for example, SOFR in dollar markets). The choice of reference index and any fixed spread can materially affect swap economics and risk.

Examples

Simple hedge example
* Company A issues $10 million in variable-rate debt at SOFR + 1% but wants rate certainty. Company B agrees to pay Company A SOFR + 1% on $10 million for two years; Company A pays Company B a fixed 4% on the same notional. If SOFR rises above the breakeven level, Company A benefits; if SOFR falls, Company B benefits.

Cross-market borrowing example
* A multinational issues a foreign-currency bond at a lower foreign fixed rate but wants to avoid exchange-rate exposure. The firm can enter a swap to convert the foreign fixed payments into domestic-currency fixed or floating payments for the bond’s duration, effectively isolating interest-cost advantages while mitigating currency risk.

Why firms use swaps

• Hedging: Lock in borrowing costs or convert existing liabilities to a preferred rate profile.
• Risk management: Align cash flows, reduce exposure to interest-rate volatility, or change the tenor/index of floating-rate obligations.
• Speculation: Take directional views on future interest-rate movements.
• Arbitrage/financing: Exploit comparative advantages in borrowing in one market and swapping into another desired rate.

Key risks and considerations

• Counterparty risk: OTC swaps expose each party to the possibility the other will default; central clearing or collateral agreements reduce but do not eliminate this risk.
• Basis risk: Mismatches between the reference rate on the swap and the rate that actually affects the underlying asset or liability can leave residual exposure.
• Liquidity and margining: Large or bespoke swaps can be less liquid and may require margin postings if centrally cleared.
• Accounting and regulatory treatment: Swaps can have complex accounting impacts (hedge designation, fair value measurement) and regulatory capital implications.

Bottom line

Interest rate swaps are flexible OTC derivatives used to reallocate interest-rate exposure between parties without exchanging principal. They are widely used for hedging, managing cash-flow profiles, and accessing more favorable financing structures. Understanding the contract terms, reference rates, and counterparty/market risks is essential before entering a swap.