Interest Rate Swaps

An interest rate swap is a contract in which two parties exchange interest payments on a notional amount of money that is never itself exchanged. In the most common type, one side pays a fixed rate and the other pays a floating rate that resets periodically, such as the Secured Overnight Financing Rate (SOFR) in the US. Interest rate swaps are the largest derivatives market in the world by notional amount, used by companies, banks, pension funds and governments to manage interest rate risk.

How a plain vanilla swap works#

Only the net difference is exchanged on each payment date.

Benchmarks: from LIBOR to SOFR#

Swaps historically referenced LIBOR, a rate based on bank submissions. After scandals over LIBOR manipulation in the early 2010s, regulators led a global transition to overnight rates based on actual transactions: SOFR in the US, SONIA in the UK, €STR in the euro area. US dollar LIBOR panels ended in June 2023. See Market Manipulation.

The swap rate#

The fixed rate on a new swap, the swap rate, is set so the swap has zero value at the start: the present value of expected floating payments equals the present value of fixed payments. Swap rates for different maturities form the swap curve, which is closely watched alongside the Treasury curve. See Yield Curves.

swap spread = swap rate - Treasury yield of same maturity

Swap spreads can be negative, as for 30 year US swaps in recent years, reflecting factors such as bank balance sheet costs and demand for long dated hedges.

Valuation over time#

After a swap starts, its value changes as rates move:

• Rates rise: the fixed payer gains (they lock in a lower fixed rate than new swaps).
• Rates fall: the fixed receiver gains.

A receive fixed swap behaves much like owning a bond financed at a floating rate; a pay fixed swap behaves like being short a bond. A swap's interest rate sensitivity is measured by its DV01. See DV01 and Duration.

Uses#

Clearing and regulation#

After the 2008 crisis, regulators required most standard swaps to be centrally cleared through clearing houses such as LCH and CME, with initial and variation margin. Uncleared swaps must post margin too. This reduced counterparty risk compared with the bilateral market before 2008. See Market, Credit and Counterparty Risk and Clearing Houses and Central Counterparties.

Risks#

• Interest rate risk: values move with rates.
• Counterparty risk: reduced but not eliminated by clearing.
• Liquidity risk: margin calls can strain cash, as UK pension funds using liability driven investment strategies found during the September 2022 gilt crisis, when sharp rises in gilt yields triggered large collateral calls.
• Basis risk: the hedged loan's rate may not match the swap's floating index exactly.

Frequently asked questions#

What is an interest rate swap?#

A contract in which two parties exchange interest payments, usually fixed for floating, on a notional amount that is not exchanged.

Why do companies use interest rate swaps?#

To convert floating rate debt into fixed rate debt, or the reverse, to manage interest rate risk and match their financing to their needs.

What replaced LIBOR in swaps?#

Overnight rates based on actual transactions, such as SOFR in the US, SONIA in the UK and €STR in the euro area.

Next, see the wider family of swaps in Swaps Explained.