Interest Rate Swap: Definition, Types, and Real-World Example

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An interest rate swap is an over-the-counter derivative contract in which two parties agree to exchange streams of interest payments, calculated on the same notional principal, for a set period. In the standard version, one side pays a fixed rate and the other pays a floating rate tied to a benchmark such as the Secured Overnight Financing Rate (SOFR), which has replaced LIBOR as the main floating-rate benchmark for US dollar swaps. The principal itself never changes hands. It only serves as the base for calculating each payment.

How an interest rate swap works

Each swap has two legs. The fixed leg pays a rate agreed at the start, known as the swap rate. The floating leg resets on scheduled dates to the current level of the chosen index, often plus or minus a spread. The contract also sets the notional amount, the maturity (the tenor), the payment frequency of each leg and the day-count convention used to calculate the accrued interest.

Cash flows settle on scheduled dates, typically quarterly or semiannually, and the two legs need not share a schedule. For example, a fixed leg can pay semiannually while the floating leg pays quarterly. When both legs fall due on the same date, the payments are usually netted: only the difference moves, from whichever side owes more. Netting reduces the cash that changes hands and the amount exposed if the other party fails to pay.

Market terminology centers on the fixed leg. The party paying fixed is the payer, and is said to be long or to have “bought” the swap. The party receiving fixed is the receiver, and is said to be short or to have “sold” the swap. A payer gains when rates rise, because its floating receipts increase while its fixed payments stay the same. A receiver gains when rates fall.

Calculating the payments

For any single period, the net payment to the fixed-rate payer is:

Net payment = Notional × (Floating rate − Fixed rate) × Accrual fraction

The accrual fraction is the period length under the contract’s day-count convention, for example 0.25 for a quarter on a simplified basis. A positive result means the payer receives money. A negative result means the payer pays.

Interpreting the value

At inception, the fixed rate is normally set so that the two legs have about equal expected value, so the swap starts near zero for both sides. After that, its mark-to-market value moves with rates: when market swap rates rise above the contract’s fixed rate, the payer’s position gains value and the receiver’s loses. A quoted swap rate, such as a 10-year USD swap rate, is the market’s price for exchanging fixed for floating over that tenor, so a rising swap rate means fixed-rate funding for that term has become more expensive.

Types of interest rate swaps

Fixed-to-floating

A company that can issue a fixed-rate bond on attractive terms but prefers floating-rate exposure can receive fixed and pay floating on a swap matched to the bond’s maturity and payment dates. The fixed receipts offset the bond coupons, leaving the company effectively paying the floating index plus or minus a spread that reflects market conditions and its credit standing.

Floating-to-fixed

A borrower with access only to floating-rate loans can lock in a fixed cost by paying fixed and receiving floating on a swap whose reset and payment dates mirror the loan. The floating receipts cover the loan interest, so the swap’s fixed rate effectively becomes the borrowing rate.

Float-to-float (basis swap)

In a basis swap, both legs float, but on different indexes or tenors. A firm might swap three-month SOFR for six-month SOFR to match other cash flows. It might also switch to a different index entirely, such as the federal funds rate, commercial paper rates or Treasury bill rates.

Example of an interest rate swap

The following is a hypothetical example. Company A has $10 million of two-year floating-rate debt that costs SOFR + 1%. It worries that rates will rise, so it enters a swap with Company B on a $10 million notional. Under the swap, A pays a fixed 4% and receives SOFR + 1%. For simplicity, assume annual settlement and a full-year accrual.

• If SOFR is 2%: A receives 3% ($300,000) and owes 4% ($400,000). The two amounts net to a $100,000 payment from A to B.
• If SOFR is 5%: A receives 6% ($600,000) and owes 4% ($400,000). B pays A a net $200,000.

In both cases, the swap receipts cover the SOFR + 1% owed on the loan, so A’s all-in cost stays at 4% no matter where SOFR goes. B comes out ahead if rates stay below the break-even level and behind if they rise above it.

Why companies and institutions use swaps

• Hedging: Converting uncertain floating costs into fixed ones, or the reverse, without refinancing the underlying debt.
• Asset-liability matching: Banks with fixed-rate assets and floating-rate funding, or the opposite, use swaps to close the gap.
• Cheaper funding: A borrower raises money in whichever market offers the best terms, then swaps into the rate type it wants.
• Speculation: Traders and funds take payer or receiver positions to express a view on rates.
• Duration management: Fixed-income managers receive fixed to lengthen portfolio duration or pay fixed to shorten it.

Limitations and risks

• Counterparty risk: In an uncleared swap, the other party may default while owing net payments or while the swap has positive value to you. Central clearing, which became mandatory for many standardized swaps after the 2008 financial crisis, places a clearinghouse between the two parties and requires margin.
• Opportunity cost: A floating-to-fixed hedger keeps paying fixed even if rates fall, and the swap shows a loss on its books.
• Exit cost: Ending a swap early means settling its current market value. That can require a sizable payment if rates have moved against you.
• Basis and mismatch risk: If the swap’s index, dates or spread do not exactly match the debt being hedged, the hedge is imperfect.
• Complexity: Valuation, day counts and documentation (often under ISDA agreements) take expertise to manage.

What is commonly confused with an interest rate swap

A cross-currency swap exchanges both interest payments and principal in two different currencies, typically when a company borrows abroad and wants to remove exchange-rate risk. A plain interest rate swap involves one currency and no principal exchange. Unlike futures, which are standardized and exchange-traded, swaps are bilateral and customizable. Finally, a swap is an obligation, not a right: unlike options, neither party can walk away when rates move against it.

FAQs

The Bottom Line

Interest rate swaps matter to borrowers, banks and fund managers who want to change their exposure to rates without refinancing debt. A swap can lock in a fixed borrowing cost or convert fixed payments to floating, but it is a binding obligation. Users should match the swap's index, dates and spread to the debt being hedged and weigh counterparty, exit and opportunity costs before entering.