Interest Rate Swap

Interest rate swaps are used to manage exposure to changes in interest rates. The notional principal is not exchanged; only the difference between the interest payments is usually paid.

For example, a company has a 10 million loan with a floating interest rate. Worried that rates will rise, it enters a swap agreeing to pay a fixed rate of 4% and receive the floating rate. If the floating rate is 3.5% in a year, the company pays the net difference of 0.5%, or 50,000, to the swap counterparty. If the floating rate rises to 5%, it receives 100,000. Combined with its floating-rate loan, the company has effectively locked in a cost of 4%.

Banks use swaps to manage the mismatch between their fixed-rate loans and floating-rate deposits. Investors use them to adjust the interest rate sensitivity of their portfolios. Speculators use them to bet on interest rate movements.

Floating rates in swaps are linked to benchmarks such as SOFR in the United States, SONIA in the United Kingdom and €STR in the euro area, which have replaced the older LIBOR benchmarks, now discontinued. Interest rate swaps are the largest segment of the global derivatives market.