Interest Rate Swap

An interest rate swap (IRS) is an over-the-counter derivative in which two counterparties agree to exchange periodic interest payments calculated on the same notional amount for an agreed period. In the most common form, the plain vanilla swap, one party pays a fixed rate and the other pays a floating rate that resets to a benchmark at each period. The notional principal is a reference figure only: it is never exchanged, and in practice the two interest amounts due on the same date are netted so that only the difference changes hands.

Interest rate swaps are among the largest financial markets in the world by notional outstanding. Banks, companies, insurers, pension funds and governments use them to change the interest-rate profile of their assets or debts without refinancing, and dealers and hedge funds use them to take views on the path of rates.

A swap is defined by its notional amount, its start and maturity dates, the fixed rate, the floating index and the payment frequency of each leg. The party paying fixed is said to be the payer of the swap and is effectively protected if rates rise; the party receiving fixed benefits if rates fall. At inception the fixed rate is set so that the present value of both legs is equal, which means the swap has a value of roughly zero to both sides. As market interest rates move, the swap gains value for one party and loses it for the other.

Floating legs historically referenced LIBOR. After regulators announced the end of LIBOR, US dollar swaps moved to the Secured Overnight Financing Rate (SOFR), sterling swaps to SONIA and euro swaps largely to €STR. Most USD LIBOR settings stopped being published in representative form after 30 June 2023. Swaps on overnight rates are often called overnight index swaps (OIS).

A company has borrowed USD 10 million at a floating rate of SOFR plus 1.50 percent and wants certainty about its interest cost. It enters a five-year swap with a bank on a notional of USD 10 million, paying a fixed 4.00 percent and receiving SOFR, with annual settlement for simplicity.

• If SOFR averages 5.00 percent in a year, the company owes the bank 400,000 and is owed 500,000; the bank pays the net 100,000 to the company.
• If SOFR averages 3.00 percent, the company owes 400,000 and is owed 300,000; the company pays the net 100,000 to the bank.

In both cases the company still pays SOFR plus 1.50 percent to its lender, but the swap converts that cost into a fixed 5.50 percent all-in. Each change of one basis point in the swap rate moves the swap's value by roughly the notional multiplied by the remaining duration and by 0.0001.

• Hedging debt. Borrowers fix the cost of floating-rate loans, or convert fixed-rate bonds into floating exposure, as part of ordinary hedging.
• Asset-liability management. Banks use swaps to manage the gap between fixed-rate loans and floating-rate deposits, protecting their net interest margin and limiting the interest-rate risk that comes with maturity transformation.
• Market views and pricing. Swap rates across maturities form a curve that sits alongside the government bond yield curve and is a benchmark for pricing loans and bonds.

Swaps developed in the early 1980s from earlier parallel and back-to-back loans. A 1981 transaction between IBM and the World Bank is often cited as the first prominent currency swap, and fixed-for-floating interest rate swaps followed within a few years. The International Swaps and Derivatives Association (ISDA), founded in 1985, produced the master agreement that still documents most bilateral trades.

After the 2008 financial crisis, G20 leaders agreed that standardized over-the-counter derivatives should be cleared through a central counterparty (CCP) and reported to trade repositories. In the United States this was implemented through the Dodd-Frank Act and in the EU through EMIR. Cleared swaps require initial and daily variation margin, and a large adverse move can produce a margin call. Uncleared swaps between large firms are subject to separate margin rules.

An interest rate swap can be viewed as a series of forward rate agreements bundled together, and is closely related to the forward contract and the futures contract. It differs from a currency swap, where payments are in two currencies and principal is usually exchanged, and from an FX swap, which is a short-term spot and forward exchange of currencies. A credit default swap, despite the name, transfers credit risk rather than interest-rate risk.

The main risks are market risk from rate movements, counterparty credit risk if the other side defaults while the swap has positive value, and liquidity risk from collateral calls. Swaps can also be mis-sold: in several countries, banks were required to compensate small businesses that had been sold complex interest-rate hedging products they did not understand.