Interest Rate Swap
Also known as: IRS, Fixed-for-floating swap
Swap fixed interest for floating: the workhorse of global finance, and the largest derivatives market there is.
1 · SnapshotThe one idea to remember
2 · BeginnerWhat is it, really?
An interest rate swap is a deal to exchange two kinds of interest on the same notional amount: one side pays a fixed rate agreed today, the other pays a floating rate that resets with the market. Only the interest difference changes hands — the notional never moves.
Why would anyone? Because rate risk is everywhere. A company with floating-rate debt fears rate rises: it enters a swap to pay fixed and receive floating — its floating loan cost is now offset, and it effectively pays a known fixed rate. A pension fund needing long-term fixed income does the reverse.
Swaps are the largest derivatives market on the planet, measured by notional outstanding, because they are the cheapest tool ever devised for moving interest-rate risk from those who fear it to those paid to hold it.
a paymentonly if a condition is metnot a payment
A borrower swaps an uncertain payment for a certain one. Only the difference between the two legs ever moves.
At the start
- Fixed-rate payer → Fixed-rate receiver The fixed rate is set so the swap is worth zero on day one. There is no premium, which is why it costs nothing to enter and a great deal to leave.
Every period, for years
- Fixed-rate payer → Fixed-rate receiver Known from the first day to the last. This is the number the borrower can put in a budget, and the whole reason for the trade.
- Fixed-rate receiver → Fixed-rate payer Reset from a published index each period, and handed straight on to service the underlying floating-rate loan.
netted: only the difference moves
What is never exchanged
- Fixed-rate payer → Fixed-rate receiver It is a measuring stick. Nothing is lent, nothing is repaid, and only the net difference between the two legs is actually paid.
If the borrower wants out early
- Fixed-rate payer → Fixed-rate receiver A swap that has moved against you has to be bought back at its value. Entering was free; leaving is not.
Clearing, and why a swap consumes cash dailyafter the trade
a paymentonly if a condition is metnot a payment
Standard shapes must be cleared. That turns a paper loss into a payment today, which is the mechanism behind the 2022 LDI episode.
Once agreed
- Either side → Clearing house The original pair stop facing each other; each faces the clearing house.
- Either side → Clearing house Posted by both sides and held for the life of the trade.
Every single day
- Clearing house → The other side The day's change in value is paid and settled permanently. It is a payment, not a pledge.
If a call is missed
- Clearing house → Either side A clearing house does not negotiate. The loss that gets crystallised is the market's, not the model's.
- Asset class
- Rates derivatives
- Instrument type
- Swap (linear)
- Traded
- OTC, mostly centrally cleared
- Typical users
- Banks, corporates, pensions, funds
Which risks decide the outcome
Not how risky this is, and not a rating — there is deliberately no total. It says which of five failure modes drives what happens here, in the same order on all 129 products so they can be compared. This publication's own reading; see the notice below.
- Marketdecides it
- Creditbarely applies
- Liquiditybarely applies
- Fundingdecides it
- Operationalbarely applies
What decides it here. Nothing is lent, so credit is small and funding is everything: a position that has moved against you consumes cash today whatever it is worth at maturity. That is the 2022 LDI episode in one sentence.
3 · IntermediateHow it works in practice
Anatomy of a standard swap
- Notional: reference amount, e.g. $100M (never exchanged).
- Fixed leg: the "swap rate", paid annually/semi-annually — this is what's quoted.
- Floating leg: today, compounded overnight rates (SOFR, €STR) paid periodically — the post-LIBOR standard.
- Clearing: most swaps clear at CCPs (LCH, CME) with daily margin; the credit risk of old bilateral swaps is largely gone.
The swap curve
Swap rates quoted across maturities form the swap curve — effectively the market's fixed-income backbone, often more liquid than government bonds. A swap's fixed rate equals the average of expected floating rates over its life (plus tiny adjustments), so the curve is a readout of expected central-bank policy.
Marking to market
Rates move, and your swap gains or loses value. Pay fixed at 3% and the 10-year swap rate rises to 4%? Your position is a winner: you locked cheap fixed payments. Receivers profit when rates fall. A 10y swap's sensitivity: roughly $80k per basis point per $100M notional.
4 · AdvancedPricing & valuation
Pricing: two legs, one curve (now)
Value each leg on the OIS discount curve \(P(0,t)\). The floating leg (paying the same overnight index used for discounting) is worth par-like telescoping sums; the fair swap rate makes the legs equal:
What the symbols mean
- Sthe price of the underlying today
- Pa price, or a present value
- Tmaturity, in years
- nhow many periods, or how many things
- deltaa small change in whatever follows
— the swap rate is a discount-weighted average of forward rates \(f_i\). The denominator \(A = \sum \delta_i P(0,T_i)\) is the annuity; a seasoned swap's value is \(V = (S_{now} - S_{traded})\times A\times N\) for the receiver of \(S_{traded}\)… with sign per side.
Risk language
- DV01: dollar value of a basis point, ≈ \(A \times N \times 10^{-4}\).
- Curve risk: bucketed key-rate DV01s; traders trade 2s10s steepeners, butterflies, etc., as spread packages.
- Convexity/gamma: linear at first order; second-order effects matter at size and in spread trades vs. futures.
The multi-curve legacy
Pre-2008, one LIBOR curve did projection and discounting. The crisis broke that: OIS discounting, tenor bases, and cross-currency bases created the multi-curve framework. RFR reform re-simplified domestic swaps (projection = discounting = OIS) but bases persist across currencies and legacy tenors.
Swap spreads
Swap rate minus government yield at the same maturity — driven by balance-sheet costs, issuance flows and collateral scarcity; famously negative at long US maturities since 2015, a standing puzzle priced as the cost of dealer intermediation.
The formulas above are standard textbook formulations, simplified for teaching. They explain the mechanism — they are not a valuation tool, and they will not reproduce a dealer’s price.
5 · Desk notesHow practitioners think about it
Now say it back
Close the page and give Interest Rate Swap in four sentences. It takes a minute and it is the only way to find out whether reading it was enough.
- Who wants what — two parties wanted opposite things badly enough to write it down.
- What the contract obliges, and when — not the payoff; the obligation.
- Where the money comes from — name the source, or you have described a hope.
- What makes it lose — the ordinary way, not the dramatic one.
Put Interest Rate Swap beside any other instrument →
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