What Is an Interest Rate Swap?
An interest rate swap is an agreement between two counterparties to exchange streams of interest payments over a set period. In the standard version, called a plain vanilla swap, one side pays a fixed rate while the other pays a floating rate that resets periodically based on a benchmark, which in the US is now SOFR after the retirement of LIBOR.
The payments are calculated on a notional principal amount that is never actually exchanged. If a company enters a $100 million swap paying 4% fixed and receiving floating, only the net difference between the two interest amounts changes hands on each payment date.
How a Swap Works
Suppose a company has borrowed $100 million at a floating rate of SOFR plus 2% but wants payment certainty. It enters a swap where it pays a dealer 4% fixed and receives SOFR. The received SOFR offsets the SOFR on its loan, leaving the company with an all-in fixed cost of roughly 6% regardless of where rates move.
The fixed rate on a new swap, called the swap rate, is set so the contract has zero value to both sides at inception, meaning the present value of the expected fixed and floating legs is equal. As rates move afterward, the swap gains value for one party and loses value for the other, and since Dodd-Frank most standard swaps are cleared through central counterparties to manage that credit exposure.
Why Swaps Matter
Interest rate swaps dominate global derivatives activity, with hundreds of trillions of dollars in notional outstanding according to BIS data. Corporations use them to convert floating-rate debt to fixed or vice versa, banks use them to manage the mismatch between assets and liabilities, and investors use them to express views on the direction of rates without trading bonds.
For anyone recruiting into markets roles, swaps are foundational. Rates desks at every major bank trade them all day, swap spreads are a key market indicator, and debt capital markets bankers routinely pair a bond issuance with a swap so the issuer ends up with the rate profile it actually wants.
