Interest Rate Swaps Explained with a Fixed-Floating Example
A plain-vanilla interest-rate swap exchanges interest cash flows based on a notional amount, usually one fixed-rate stream and one floating-rate stream in the same currency. The notional normally serves as the calculation reference rather than changing hands. Swaps can hedge financing risks, but expose counterparties to market value, collateral and benchmark risks.
How the two legs work
One side pays a contractually specified fixed rate; the other pays a rate linked to a floating benchmark over defined accrual periods. The parties agree maturity, notional, payment frequency, day-count conventions and reference-rate rules. Many institutional swaps are centrally cleared or subject to bilateral collateral arrangements. A common way to describe the position is ‘pay fixed, receive floating’ or its reverse; the economic risk depends on the full contract terms.
Worked example: one payment period
Suppose a fictional £10 million swap has a 4.0% annual fixed rate and a floating rate of 4.6% for a three-month accrual period taken as 0.25 year. The fixed payment is £10m × 0.04 × 0.25 = £100,000. The floating payment is £10m × 0.046 × 0.25 = £115,000. If the contract nets payments on that date, the fixed-rate payer receives a net £15,000 before other adjustments. Actual calculations may compound overnight benchmark rates and use precise day counts.
Why the initial swap may have near-zero value
At initiation, a market-standard fixed swap rate is normally set so the present value of the fixed leg approximately equals the floating leg, subject to charges and collateral conventions. As expected future floating rates or discount curves change, the swap acquires positive or negative mark-to-market value. The original fixed rate does not ‘track’ subsequent market rates; it remains the contracted payment rate.
Pay-fixed versus receive-fixed exposure
A pay-fixed, receive-floating swap generally benefits in value from rising relevant market swap rates, all else equal; a receive-fixed position generally benefits from falling rates. The magnitude depends on maturity, projected cash flows, collateral and curve shape. This directional simplification is not a substitute for full valuation under a curve model, especially when an instrument has basis, amortising notional or embedded optionality.
Corporate hedging illustration
Consider a company with floating-rate debt linked to SONIA. It may pay fixed and receive SONIA under a swap to offset some variability in the interest expense on its borrowing. If the loan includes a credit spread, fees or a different reset formula, the hedge can leave basis risk. It may also create collateral cash calls when the swap’s market value changes. The swap does not eliminate the principal obligation or the company’s credit risk.
Reference rates and compounding conventions
Sterling SONIA measures eligible wholesale unsecured overnight deposit rates; US SOFR reflects overnight Treasury-secured financing transactions. Contracts may compound daily overnight rates over payment periods, sometimes with observation shifts or lags. A three-month swap cash flow is not necessarily computed from one published three-month ‘spot’ rate. Read the confirmation or published standard before modelling exact floating-leg payments.
Discounting and counterparty treatment
Modern collateralised swaps may discount future cash flows using an overnight index curve consistent with collateral terms, while other transactions may use different valuation adjustments. A swap’s credit exposure and margin requirements differ from owning a fixed-rate bond. Clearinghouses can reduce bilateral exposure but introduce specific margin, default-management and operational obligations.
How to analyse a swap safely
Verify notional currency, direction, fixed rate, benchmark, spreads, maturity, settlement dates, day counts, compounding and collateral. Calculate a sample coupon, then compare expected cash flows and current market swap rates. Run rate-curve scenarios rather than assuming a fixed amount of profit for every policy-rate change.
Fixed-for-floating swap cash-flow comparison
Illustrative £10 million, three-month period; simplified 0.25-year accrual factor.
| Cash-flow leg | Calculation | Amount |
|---|---|---|
| Fixed leg paid | £10,000,000 × 4.0% × 0.25 | £100,000 paid |
| Floating leg received | £10,000,000 × 4.6% × 0.25 | £115,000 received |
| Net cash flow | £115,000 − £100,000 | £15,000 received by fixed-rate payer |
| If floating rate were 3.5% | £87,500 received − £100,000 paid | £12,500 net payment |
This illustrates cash-flow mechanics, not the full market value of the swap. A contract’s mark-to-market value depends on the present value of all future fixed and floating cash flows, discount curves and collateral arrangements. Most modern overnight reference-rate swaps use compounded floating observations with specified day-count and payment-lag rules, so the assumed 4.6% constant quarterly rate is only a teaching device. The hypothetical payer would not necessarily receive £15,000 on a real contract with these simplified headline inputs.
Frequently asked questions
Does swap notional usually exchange hands?
Not for a standard single-currency fixed-floating interest-rate swap.
Can a hedge swap lose value?
Yes. Its market value can move adversely even if it offsets another exposure.
Are SONIA and SOFR the same?
No. SONIA is sterling unsecured overnight; SOFR is US-dollar Treasury-secured overnight financing.
Sources and further reading
Continue learning with Bond Valuation Fundamentals in the Traders MBA Education library.