Interest Rate SwapIRS
An interest rate swap is an agreement where one party pays a fixed interest rate and the other pays a floating rate on the same notional amount. Only the net difference changes hands; the notional principal is never exchanged.
A company with a floating-rate loan worries rates will rise. Instead of refinancing, it enters an interest rate swap: it pays a fixed rate and receives a floating one, effectively locking its borrowing cost. Interest rate swaps are the largest derivatives market by notional value. This entry explains how they work, with examples.
- Category
- Derivatives
- Reading time
- 3 min
- Also called
- IRS, Fixed-for-floating swap, Plain vanilla swap
- Updated
Interest rate swaps in plain words
Most interest rate swaps exchange a fixed rate for a floating rate: one side pays fixed and receives floating, the other does the reverse.1
Only the net difference in interest is exchanged, based on a notional principal that never changes hands.1
Floating rates were long tied to LIBOR, which has been phased out and largely replaced by SOFR.2
How an interest rate swap works, step by step
Set the notional
E.g. $50m, never exchanged.
Agree the fixed rate
The swap rate.
Pick the floating index
Now usually SOFR. See SOFR.
Set payment dates
Quarterly or annually.
Net the payments
Only the difference is paid.
Track value
Mark to market as rates move.
Worked examples
Example 1 — Locking a loan rate
5.5% lockedA company has a $20m loan at SOFR + 1.5%. It swaps to pay 4% fixed and receive SOFR.
| Loan cost | SOFR + 1.5% |
| Swap | Pay 4%, receive SOFR |
| Net cost | 4% + 1.5% = 5.5% fixed |
Paying fixed and receiving floating converts a floating-rate loan into fixed cost.1
Example 2 — Rates rise
Hedge pays $200kSOFR rises to 5%; the company pays 4% fixed on $20m.
| Receives | 5% × $20m = $1m |
| Pays | 4% × $20m = $800k |
| Net received | $200k |
Only the net difference changes hands, offsetting the higher loan cost.1
Example 3 — Rates fall
Pays $400kSOFR drops to 2%.
| Net paid | (4% − 2%) × $20m = $400k |
The swap removes the benefit of falling rates — the price of certainty. See Hedging.
Pay-fixed vs receive-fixed
| Aspect | Pay fixed | Receive fixed |
|---|---|---|
| Benefits when rates | Rise | Fall |
| Typical user | Floating-rate borrowers | Fixed-income investors |
| Similar to | Shorting bonds | Owning bonds |
| See also | Swap rates | Bond |
Who uses interest rate swaps
Companies
Fixing loan costs. See Interest Rate.
Banks
Matching assets and liabilities.
Pension funds
Hedging long-term liabilities.
Speculators
Betting on rate moves. See Fed Funds Futures.
Advantages and disadvantages
Advantages
- Hedges rate risk without refinancing.
- Flexible terms.
- Deep, liquid market.
Disadvantages
- Gives up gains if rates move favourably.
- Counterparty and collateral needs.
- Termination can be costly.
Going deeper
Read as far as you need. Each level builds on the one before it.
Notional isn't exchanged
Beginner
The notional amount only sizes payments; the principal itself is never exchanged.1
The LIBOR switch
Intermediate
Swap spreads
Advanced
The gap between swap rates and Treasury yields reflects bank credit, supply and demand, and is watched as a market stress signal. See Treasury Bills, Notes and Bonds.
Common mistakes
Thinking notional is at risk
Only payment differences are.
Ignoring mark-to-market losses
Swap values swing with rates.
Mismatching loan and swap dates
Leaves gaps in the hedge.
Forgetting collateral calls
Can strain cash.
Check your understanding
Test yourself before moving on. Each answer comes with an explanation.
Key points to remember
- An IRS exchanges fixed and floating interest payments.
- Only the net difference is paid.
- The notional isn't exchanged.
- Paying fixed protects against rising rates.
- SOFR replaced LIBOR as the main floating index.
Frequently asked questions
What is the swap rate?
Why not just get a fixed-rate loan?
Who is on the other side?
Further learning
Sources
This article is written in our own words. The sources below support the specific facts, rules and figures marked with a number in the text. Links open the original publisher’s page.
- Corporate Finance Institute. Interest Rate Swap (opens in a new tab) Checked .
- Corporate Finance Institute. LIBOR: Why It Was Phased Out and What Replaced It (opens in a new tab) Checked .
Educational content, not financial advice. Examples use hypothetical prices and simplified costs; actual fees, margin rules and regulations vary by broker, market and country. We are not affiliated with any publisher linked above. Last reviewed . Report an error or request a source credit.