Deep Dive · Swaps · Lesson 3
How Swap
Payments Work
Big Idea
In an interest rate swap, each period both sides work out what they owe from the same notional amount — one side a fixed rate, the other a floating rate. But the two payments are not both sent in full. They are netted: the amounts are compared, and only the difference changes hands. The notional itself is never swapped — it is just the figure the payments are sized from.
- Both legs are calculated from the notional — but only the net difference is exchanged.
- The notional is never handed over — it only sizes the payments.
Two payments are computed; one small difference actually moves.
Notional, Legs, and Dates
Three things define the mechanics of a swap. The notional is the reference amount the payments are calculated from — say $10 million. The two legs are the two streams of payments: the fixed leg (based on an agreed fixed rate) and the floating leg (based on a market rate). The payment schedule is how often they settle — here, once a year.
Each leg’s payment follows one plain formula:
payment = notional × rate × time
The time factor is the fraction of a year the period covers. For the annual periods in this lesson, time = 1, so each payment is simply notional × rate. (If a period were half a year, time would be 0.5.)
Calculating Each Leg
Take a notional of $10,000,000, a fixed rate of 4%, and annual payments. The two legs are worked out like this:
- Fixed leg = notional × fixed rate = $10,000,000 × 4% = $400,000 every year.
- Floating leg = notional × that year’s floating rate = $10,000,000 × that year’s SOFR.
The fixed leg is the same $400,000 every period — it is locked in. The floating leg changes each year because SOFR (the market’s floating rate) resets to a new level for each period. If SOFR is 5% one year, the floating leg is $10,000,000 × 5% = $500,000 for that year.
Netting: Only the Difference Changes Hands
On each payment date, the two legs are compared and only the difference is paid — the party that owes more sends the shortfall to the other. This is netting. The table below takes the point of view of the party who pays the fixed leg and receives the floating leg. The fixed leg is always $400,000; the floating leg moves with SOFR.
| Year | Floating Rate (SOFR) | Floating Leg | Fixed Leg | Net to the Fixed-Payer |
|---|---|---|---|---|
| Year 1 | 5% | $500,000 | $400,000 | Receives $100,000 |
| Year 2 | 4% | $400,000 | $400,000 | $0 |
| Year 3 | 3% | $300,000 | $400,000 | Pays $100,000 |
Only the net amount moves — never the two full legs, and never the notional.
The Notional Is Never Exchanged
Notice that the $10,000,000 never appears in the “Net to the Fixed-Payer” column. In an interest rate swap the notional is only used to size the payments — it is the number both legs are calculated from, and nothing more. It never changes hands, in either direction, at any point in the swap’s life.
This is a defining feature of an interest rate swap, and it is also where the next lesson diverges. In a currency swap, the principal really is exchanged — the two sides swap actual amounts in two different currencies at the start and swap them back at the end. But for the interest rate swap here, the notional stays exactly where it is.
Interactive Checks
Check 1 of 3
You are working out one leg of the swap for a single period.
How is that leg’s payment calculated?
Check 2 of 3
It is a payment date, and both legs have been calculated.
What actually changes hands?
Check 3 of 3
A friend assumes the $10,000,000 notional gets paid over during the swap.
In an interest rate swap, is the notional exchanged?
Common Beginner Mistakes
- ❌ Thinking both full legs are paid in gross. They are netted — only the difference between the two legs actually moves.
- ❌ Thinking the notional changes hands. For an interest rate swap it never does — it only sizes the payments.
- ❌ Forgetting the floating leg resets. The fixed leg stays constant, but the floating leg is recalculated from a new SOFR each period.
- ❌ Ignoring the period fraction. When a period is not a full year, you must multiply by the time factor — notional × rate × time.
Quick Memory Tool
- Each leg = notional × rate × time
- The fixed leg is constant; the floating leg resets each period
- Only the net difference changes hands — that is netting
- The notional is never exchanged in an interest rate swap
- Example: $10M at 4% fixed → $400,000 fixed leg every year
Next Lesson
Currency Swaps — where two parties exchange principal and interest in two different currencies. Unlike an interest rate swap, the principal really does change hands.