Interest Rate Swaps Explained: What They Are, How They Work and Why Firms Use Them

An interest rate swap is an agreement between two parties to exchange interest payments on the same amount of money for a set number of years. One side pays a fixed rate. The other pays a floating rate that resets over time. Interest rate swaps are the largest part of the over-the-counter derivatives market by notional amount, and they appear in every level of the CFA Program and in both parts of the FRM.

The idea is simple once you see what actually changes hands. That is where most people go wrong.

What changes hands (and what doesn't)

A swap is written on a notional amount, say $10 million. The notional is only used to calculate the payments. It is never exchanged. Nobody pays anybody $10 million.

On each payment date, the two interest amounts are calculated:

• Fixed leg: notional × fixed rate (the swap rate agreed at the start).
• Floating leg: notional × the floating reference rate for that period. For SOFR swaps the rate is compounded over the period, so the payment is only known at the end of it. In US dollars this is now SOFR, in euros usually €STR or EURIBOR. LIBOR, the old benchmark, is gone for US dollars: the panel-based rates ended in June 2023 and the temporary “synthetic” versions in September 2024.

The two amounts are then netted: only the difference is paid, by whichever side owes more.

The party paying fixed is called the fixed-rate payer (or "pay-fixed"). The other is the fixed-rate receiver.

A worked example

A company has a three-year, $10 million swap. It pays fixed at 4.0% and receives the floating rate, with annual payments. To keep the arithmetic clean, ignore day-count conventions.

The only money that moves is $60,000, then $50,000, then nothing. On a $10 million swap, the real payments are a small fraction of the notional.

Why companies and banks use swaps

1. To fix a floating-rate loan. A company borrows $10 million at a floating rate but wants predictable interest costs. It enters a swap paying fixed and receiving floating. The floating payments it receives offset the floating interest on its loan, so what is left is the fixed swap rate plus the spread on its loan. A loan at SOFR + 1.5% with a 4.0% pay-fixed swap costs 5.5% fixed. Its loan now behaves like a fixed-rate loan, without refinancing.

2. To manage interest rate risk on a balance sheet. A bank with long-term fixed-rate mortgages funded by short-term deposits loses money if rates rise. Paying fixed on a swap gains value when rates rise, which offsets part of that loss. Insurers and pension funds use receive-fixed swaps the other way, to add duration to match long-dated liabilities.

3. To take a view on rates. If you think rates will rise more than the market expects, paying fixed profits if you are right. If you think they will fall more than expected, receiving fixed does.

How a swap's value moves

At the start, the fixed rate is set so the swap is worth zero to both sides (ignoring dealer spreads and credit adjustments). That fixed rate is the swap rate. Nobody pays anything to enter.

After that, the value changes as rates move. A useful way to see it:

• Pay fixed, receive floating = short a fixed-rate bond and long a floating-rate note.
• Receive fixed, pay floating = long a fixed-rate bond and short a floating-rate note.

A floating-rate note stays close to par because its coupon resets. So the swap's value comes mostly from the fixed-bond side. When rates rise, fixed-rate bonds fall in value, so a pay-fixed swap gains and a receive-fixed swap loses. A pay-fixed swap therefore has negative duration.

To value a swap after it starts, discount the remaining fixed payments and the expected floating payments at current rates, and take the difference. In the bond view, the floating-rate note is worth par at each reset date, which is why the valuation mostly comes down to the fixed side.

The risks

Counterparty credit risk. If the other side defaults when the swap is worth money to you, you lose that value. The loss is limited to the swap's market value, not the notional, because the notional is never exchanged. Since the 2008 crisis, standard interest rate swaps in the US and Europe must usually be centrally cleared, and both sides post initial and variation margin to the clearing house as the value changes. Swaps that are not cleared face mandatory margin rules too. This cuts counterparty risk a lot.

Market risk. The swap's value moves with rates, as above.

Other kinds of swap

• Currency swap: each side pays interest in a different currency, and the notional amounts are usually exchanged, at the start and again at the end. That is the key difference from an interest rate swap.
• Equity swap: one side pays the return on a stock or index, the other pays a fixed or floating rate (or the return on another index). If the equity return is negative, the side paying it receives that amount instead.
• Credit default swap: one side pays a regular premium, the other pays out if a borrower defaults. It works more like insurance than an exchange of interest payments.

Where swaps appear on the exams

• CFA Level I (Derivatives, 5–8% of the exam): what a swap is, how it can be seen as a series of forward contracts, and the bond-portfolio view above.
• CFA Level II: pricing and valuing swaps from a set of discount factors.
• CFA Level III: using swaps to change portfolio duration.
• FRM Part I (Financial Markets and Products): mechanics, the comparative-advantage argument, valuing swaps, and currency swaps.

The three mistakes that cost marks

1. Thinking the notional is exchanged in an interest rate swap. It isn't; in a currency swap it usually is.

2. Getting the direction wrong. Rates up: pay-fixed gains, receive-fixed loses.

3. Mixing up the swap rate and the floating rate. The swap rate is the fixed rate set at the start; the floating rate resets every period.

Want to check you have it? The derivatives sets in the JephAi Questions Bank include swap questions at every level, each with a worked explanation.