Interest Rate Swap

An interest-rate swap (IRS) is a swap contract where one party pays a fixed interest rate and receives a floating rate (typically SOFR or another index), while the counterparty does the opposite. No principal is exchanged; only interest rate differences are settled periodically. Interest-rate swaps are the most-traded derivatives globally, used by banks, corporations, and investors to manage interest-rate risk and match assets to liabilities.

How interest-rate swaps work

A corporation borrows $50M at floating SOFR + 1% for 5 years. It wants to lock in a fixed cost. It enters a 5-year IRS with a bank:

On each quarter:

• Corporation pays bank: Fixed 4% on $50M = $500K
• Bank pays corporation: SOFR + 1% on $50M = (SOFR + 1%) × $50M

Net result: Corporation pays fixed 4%; any change in SOFR doesn’t affect the corporation’s total payment.

If SOFR is at 5%, the corporation’s floating cost is 6%, but it pays 4% fixed via the swap, netting 4% total.

Why corporations use IRS

Floating to fixed: A floating-rate borrower locks in costs, avoiding rate-rise risk.

Fixed to floating: A fixed-rate borrower—if it believes rates will fall—swaps to floating to benefit from the decline.

Liability-asset matching: An investor with fixed-rate bonds but floating-rate liabilities swaps to align maturities and durations.

Swap pricing

The fair fixed rate is determined by the yield curve. For a 5-year swap, the fixed rate is approximately the 5-year par swap rate—the rate at which the present value of fixed payments equals the present value of expected floating payments.

As the yield curve shifts, swap rates shift. A flattening curve typically lowers longer-dated swap rates.

Marked-to-market values

When you enter a swap at par (fixed rate set to be fair), its value is zero. As rates move, the value changes.

Example:

• You pay fixed 4% (locked in). Rates rise to 5%.
• Your fixed 4% is now cheap (market wants 5%).
• Your swap has positive value; you could sell it for a gain.

The fixed-rate payer gains when rates rise; the floating-rate payer gains when rates fall.

Counterparty risk and clearing

Swaps are bilateral contracts with counterparty risk. If the bank defaults after rates have moved significantly, you lose the present value of the remaining cash flows.

Post-2008, standardized IRS are increasingly cleared through central counterparties (LCH Swapclear, CME, etc.), reducing bilateral risk and requiring margin.

SOFR transition from LIBOR

The global derivatives market transitioned from LIBOR to SOFR (Secured Overnight Financing Rate) in 2021–2023. Existing LIBOR-based swaps were converted or allowed to mature. New IRS are SOFR-based, reflecting lower counterparty risk (SOFR is repo-based, more transparent).

See also