Interest Rate Swap: How the Fixed-for-Floating Exchange Works

An interest rate swap is a derivatives contract in which one party agrees to pay a fixed rate of interest on a notional principal, while the other pays a floating rate tied to a benchmark index such as SOFR. No principal changes hands—only the difference in interest payments is exchanged. Swaps allow borrowers to change the character of their debt or investors to hedge interest rate risk, and they are the largest derivatives market by notional value.

Why Swaps Exist and Who Uses Them

A bank borrows at floating rates because customers demand floating deposits. But the bank may prefer to lock in a predictable cost. Without a swap, it must refinance at SOFR every quarter. With a swap, it pays a fixed rate to a counterparty and receives floating, mathematically converting its liability.

A corporate treasurer may have issued fixed-rate bonds but now wants floating exposure to match floating revenues. A swap converts the bond’s cost from fixed to floating.

An asset manager holding floating-rate notes may want fixed income certainty. The manager can enter a swap to pay floating and receive fixed.

The swap dealer (usually a bank) profits by quoting a bid-ask spread—the fixed rate the dealer will pay is slightly lower than the fixed rate it will receive.

The Mechanics: A Plain-Vanilla Swap

Parties agree on:

• Notional: $10 million
• Tenor: 5 years
• Payment frequency: Every 6 months
• Fixed rate: 5.00% per annum (0.05)
• Floating index: SOFR
• Floating spread: +0.30% (0.003)

There are 10 semiannual periods (6 months × 5 years).

Party A (fixed payer): Commits to pay fixed; receives floating. Party A is hedging against floating-rate increases or converting fixed borrowings to floating.

Party B (floating payer): Commits to pay floating; receives fixed. Party B wants certainty or is converting floating debt to fixed.

Cash Flow on Period 1 (Month 6)

Suppose SOFR averaged 4.70% over the first 6-month period.

• Party A pays fixed: 5.00% × $10M × (180/360) = $250,000
• Party B pays floating: (4.70% + 0.30%) × $10M × (180/360) = 5.00% × $10M × (180/360) = $250,000

Net exchange: Both pay $250,000. No cash flows occur because the rates are equal at period 1.

Cash Flow on Period 3 (Month 12)

Suppose SOFR averaged 4.20% during the second 6-month period.

• Party A pays fixed: 5.00% × $10M × (180/360) = $250,000
• Party B pays floating: (4.20% + 0.30%) × $10M × (180/360) = 4.50% × $10M × (180/360) = $225,000

Party B owes $25,000 less than Party A. Net settlement: Party A pays Party B $25,000.

Cash Flow on Period 5 (Month 18)

Suppose SOFR averaged 5.40% during the third 6-month period.

• Party A pays fixed: 5.00% × $10M × (180/360) = $250,000
• Party B pays floating: (5.40% + 0.30%) × $10M × (180/360) = 5.70% × $10M × (180/360) = $285,000

Party B owes $35,000 more than Party A. Net settlement: Party B pays Party A $35,000.

The swap continues for 10 periods. In each period, one party pays the difference in interest costs. No principal is transferred.

Why the Fixed Rate Is Set at Initiation

When the swap is struck, the fixed rate is set so the swap has zero initial value. That is, the discounted present value of expected fixed payments equals the discounted present value of expected floating payments.

If SOFR is expected to average 4.70% over the 5-year period and the spread is 0.30%, the fair fixed rate is approximately 5.00%. Party A and Party B each view the deal as fair because neither is giving up value at entry.

After initiation, if interest rates rise, the fixed payment becomes cheaper relative to future floating payments, and the swap gains value for Party A (the fixed payer). If rates fall, the swap gains value for Party B.

Hedging Interest-Rate Risk

A large pension fund holds $100 million in floating-rate corporate bonds. Floating coupons reset every quarter. The fund worries rates will fall, reducing future coupon income.

The fund enters a $100 million, 5-year interest-rate swap as the floating payer—agreeing to pay floating and receive fixed (5.00%). This locks in 5% income on the notional amount, regardless of where SOFR moves.

If SOFR falls to 3.00%, the bonds’ coupons drop but the swap pays the fund the difference (5% − 3% = 2% of notional), offsetting the loss. The fund is hedged.

Similarly, a borrower with floating debt can hedge by paying fixed via a swap, ensuring a maximum cost of debt.

Counterparty and Settlement Risk

Each party faces counterparty risk: if the other party defaults, it may owe substantial cash. Early termination or collateral posting mitigates this. Most swaps now clear through central counterparties, which reduce bilateral risk.

Settlement is typically net—only the difference in interest is exchanged, not both sides’ full amounts. This lowers operational risk and cash requirements.

Variations and Extensions

Basis swaps exchange two floating rates (e.g., SOFR vs. EURIBOR) instead of fixed for floating.

Cross-currency swaps exchange fixed or floating payments in different currencies, combining interest-rate risk and currency risk.

Swaptions are options on swaps—the right to enter a swap at a future date at a rate agreed today.

Amortizing swaps reduce notional principal over time (used to hedge amortizing loans).

Inflation swaps exchange fixed payments against inflation indexes, used by pension funds and real-assets investors.

See also