# Interest Rate Swaps

> An interest rate swap exchanges fixed interest payments for floating ones on a notional amount. Learn how swaps work, SOFR, swap rates, valuation, uses and risks.

Source: https://learn.tradelabsai.com/bonds-credit/interest-rate-swaps/  
Track: Bonds, Rates and Credit · Level: Advanced · Updated: 2026-10-03  
Publisher: TradeLabs AI (https://tradelabsai.com). Education, not financial advice.  
Cite as: TradeLabs Learn, "Interest Rate Swaps", https://learn.tradelabsai.com/bonds-credit/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

| Party | Pays | Receives |
|---|---|---|
| Fixed payer (payer swap) | Fixed rate | Floating rate |
| Fixed receiver (receiver swap) | Floating rate | Fixed rate |

Only the net difference is exchanged on each payment date.

**Example: A 5 year swap**
A company has a $50 million floating rate loan paying SOFR plus 1.5%. It worries rates will rise, so it enters a 5 year swap to pay a fixed 4.0% and receive SOFR on $50 million.

- If SOFR is 5.0% in a period, the company receives 1.0% (5.0 minus 4.0) on $50 million, about $500,000 a year, which offsets the higher loan interest.
- If SOFR is 3.0%, the company pays 1.0%, about $500,000 a year, but its loan costs less.

Either way, its total cost is fixed at about 4.0% + 1.5% = 5.5%. The company has turned a floating rate loan into a fixed rate one.

## 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](https://learn.tradelabsai.com/industry/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](https://learn.tradelabsai.com/bonds-credit/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](https://learn.tradelabsai.com/bonds-credit/dv01/) and [Duration](https://learn.tradelabsai.com/bonds-credit/duration/).

## Uses

| User | Use |
|---|---|
| Companies | Convert floating rate debt to fixed, or fixed to floating |
| Banks | Manage mismatches between assets and liabilities |
| Pension funds and insurers | Receive fixed to extend duration and match long liabilities |
| Mortgage investors | Hedge prepayment and duration risk |
| Traders and funds | Bet on rate direction or curve shape. See [Yield Curve Trades: Steepeners, Flatteners and Butterflies](https://learn.tradelabsai.com/bonds-credit/yield-curve-trades/) |
| Governments | Manage debt costs |

## 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](https://learn.tradelabsai.com/portfolio/counterparty-risk/) and [Clearing Houses and Central Counterparties](https://learn.tradelabsai.com/market-structure/clearing-houses/).

## 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](https://learn.tradelabsai.com/bonds-credit/swaps-explained/).

## Continue learning

- Next lesson: [Swaps Explained](https://learn.tradelabsai.com/bonds-credit/swaps-explained/)
- Previous lesson: [Yield Curve Trades: Steepeners, Flatteners and Butterflies](https://learn.tradelabsai.com/bonds-credit/yield-curve-trades/)
- Related: [Yield Curve Trades: Steepeners, Flatteners and Butterflies](https://learn.tradelabsai.com/bonds-credit/yield-curve-trades/): Yield curve trades bet on changes in the curve's shape rather than its level. Learn steepeners, flatteners and butterflies, DV01 weighting, carry and roll down.
- Related: [Swaps Explained](https://learn.tradelabsai.com/bonds-credit/swaps-explained/): A swap exchanges one stream of cash flows for another. Learn the main types, from interest rate and currency swaps to credit, total return and commodity swaps.
- Related: [DV01](https://learn.tradelabsai.com/bonds-credit/dv01/): DV01 measures how many dollars a bond or portfolio gains or loses for a one basis point change in yield. Learn the formula, hedge ratios and how traders use it.
- Related: [Yield Curves](https://learn.tradelabsai.com/bonds-credit/yield-curves/): The yield curve plots bond yields across maturities. Learn normal, flat and inverted curves, what drives them and why inversions have signalled recessions.
- Related: [Cross-Currency Basis](https://learn.tradelabsai.com/forex/cross-currency-basis/): The cross currency basis measures deviations from covered interest parity. Learn why it exists, why it is often negative and what it says about dollar funding.
- Related: [Market, Credit and Counterparty Risk](https://learn.tradelabsai.com/portfolio/counterparty-risk/): Learn the difference between market risk, credit risk and counterparty risk, how each is measured and managed, and real cases from Lehman Brothers to FTX.