What is an interest rate swap? Like any financial swap, interest rate swaps are agreements between two counterparties to exchange two cashflow streams. Commonly referred to as the swap legs. The key thing to know about interest rate swaps is that both of these legs are tied to interest rates. The most common type of interest rate swap is a fixed for floating swap. In this type of swap, one counterparty called the payer, pays a fixed interest rate and receives a floating or variable interest rate in return while the other counterparty called the receiver, receives the fixed rate and pays the floating rates. So you won't hear terms like buyer and seller in relation to swaps, as those can be misleading. Instead, we use the terms payer and receiver, which describe who is paying or receiving the fixed leg. Now, while there are other types of swaps, such as basis swaps, where both legs are different, floating rates fixed for float swaps dominate the market. In fact, they are the largest derivative products globally with annual notional volumes in the hundreds of trillions of dollars. So how do interest rate swaps work in practice? As the diagram shows, a swap is essentially an exchange of interest payments. In this example, the payer agrees to pay a fixed rate of 5%, also known as the swap rate to the receiver. In return, the payer receives a floating rate. That floating rate is typically tied to a money market benchmark, such as an IBOR, or more commonly today a risk-free rate or RFR like SOFR. One thing to keep in mind is that while there are standard conventions in the interbank market for payment frequency and day count conventions on both the fixed and floating legs, interest rate swaps are over the counter or OTC instruments. This means clients have the flexibility to customize features like payment frequency and day counts to match their specific needs. But why do companies use these swaps? Well, the simple answer is to manage interest rate risk. Imagine a company with a loan that has a variable interest rate. If rates rise, their payments increase by entering into a swap, they can pay a fixed rate instead protecting themselves from the risk of rising rates. So interest rate swaps are a flexible tool that companies and financial institutions use to stabilize their financing costs and manage their exposure to fluctuating interest rates. We'll look at a couple of simple examples later. One important point to mention, interest rate swaps usually have a present value or PV of zero at inception. This means neither party makes an upfront payment to enter into the swap. Why? Because the agreed swap rate is considered fair, meaning the expected value of the fixed leg and the floating leg when the swap is entered into is equal. Essentially, what's the payer gives up in fixed payments is balanced by what they expect to receive from the floating payments over the life of the swap. This is why swaps traded at the market rate are sometimes called par swaps. The value of the fixed and floating legs are equal and opposite. Making the swap fair for both parties.
