Interest Rate Swaps Explainer
An interest rate swap is a contract in which counterparties exchange payments based on different interest rates applied to a notional amount. In a common fixed-for-floating swap, one side pays a fixed rate and receives payments tied to a reference rate, while the other takes the opposite position.
The notional amount usually serves only as the calculation base rather than being exchanged. Payment dates, day-count conventions, reset lags, business-day rules, maturity, and reference-rate fallbacks determine each leg. Amounts may be netted when due.
A borrower with floating-rate debt can use a pay-fixed swap to reduce rate uncertainty, but the debt and swap remain separate contracts. Differences in reference rate, maturity, amortization, credit spreads, and reset timing can leave basis risk or even increase exposure.
Swap value changes with the yield curve, time, volatility, and counterparty credit. Clearing, collateral, daily margin, netting, and documentation reduce some risks but create liquidity and operational demands. Termination before maturity can require a significant payment at market value.
Rates are applied to a shared notional amount.
The notional usually is not transferred.
Reference rates, dates, and balances must align.
Mismatch creates basis risk.
Yield curves and credit conditions affect termination value.
Collateral can turn changes into cash needs.
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