Deep Dive · Swaps · Lesson 2
Interest Rate
Swaps
Big Idea
The interest rate swap is the most common swap of all. One party pays a fixed rate, the other pays a floating rate, and both are calculated on the same notional. It lets a borrower reshape its interest-rate exposure — most often converting a floating-rate loan into effectively fixed (or the reverse) without refinancing.
- One side pays fixed; the other pays floating — on the same notional.
- It reshapes your interest-rate exposure without touching the underlying loan.
Trade the kind of interest you pay, not the loan itself.
The Plain Vanilla Swap
The standard interest rate swap — often called the plain vanilla swap — has two legs, both worked out on the same notional and in the same currency. What differs is how each leg’s rate is set.
- The fixed leg pays a set rate agreed at the start — it never changes for the life of the swap.
- The floating leg pays a rate that resets each period to a market benchmark, so it rises and falls with rates.
- Both legs are calculated on the same notional, in the same currency.
One rate is nailed down; the other moves with the market.
The Floating Rate: SOFR
The floating leg is tied to a market benchmark that resets each period. Modern US-dollar swaps reference SOFR — the Secured Overnight Financing Rate — which measures the cost of borrowing cash overnight against US Treasuries. SOFR replaced LIBOR after LIBOR was phased out in 2023, so today’s dollar swaps are built on SOFR rather than the old benchmark.
Turning Floating Into Fixed
Picture a company with a $10 million floating-rate loan. It pays SOFR plus a margin, so its cost drifts up and down every period — and it wants predictable payments instead. So it enters a swap to pay fixed (say 4%) and receive floating (SOFR), on a matching $10 million notional.
Now watch the floating rate cancel out. The SOFR payment the company receives on the swap covers the SOFR part of the interest it owes on the loan. What is left is the fixed 4% it pays on the swap, plus its original loan margin — a payment that no longer moves with the market.
Before the Swap
Pays SOFR + margin on the loan — the cost varies every period as SOFR moves.
After the Swap
Pays about 4% + margin — the floating part cancels, leaving a fixed cost.
The floating exposure has been converted to fixed — and the loan was never touched.
Who Wants Which Side
| Position | Wants | Typically Because |
|---|---|---|
| Pay fixed, receive floating | Predictable payments | Fears rising rates / wants certainty |
| Pay floating, receive fixed | Variable payments | Comfortable with variability or expects rates to fall |
Every swap has two sides — one wants certainty, the other is happy to float.
No Loan Is Refinanced
This is the part beginners miss. The swap sits alongside the existing loan — it does not replace it. The company keeps its original floating-rate loan exactly as it was and overlays the swap on top to change its net interest rate.
The loan and the swap are two separate contracts, often with two different counterparties. It is the two of them working together that produce the fixed result — the loan supplies the debt, and the swap reshapes the interest.
Interactive Checks
Check 1 of 3
Someone asks you what actually gets exchanged in an interest rate swap.
What does it exchange?
Check 2 of 3
You are setting up a modern US-dollar interest rate swap.
Which floating benchmark does it use?
Check 3 of 3
A company has a floating-rate loan and wants predictable payments.
In a swap, it would:
Common Beginner Mistakes
- ❌ Thinking the swap replaces or refinances the loan. It overlays the loan — the loan stays exactly as it was.
- ❌ Thinking the notional is exchanged. For an interest rate swap the notional is only a reference figure; it never changes hands.
- ❌ Assuming floating is always cheaper than fixed. Floating can rise above fixed at any time — that uncertainty is the whole point of swapping.
- ❌ Forgetting the floating leg resets. It is re-set to the benchmark each period, so it is not a single number fixed for the life of the swap.
Quick Memory Tool
- Interest rate swap = fixed leg for floating leg, on one notional
- The floating leg resets to a benchmark — SOFR in USD
- Pay fixed / receive floating to convert a floating loan to fixed
- The swap overlays the loan — it does not replace it
- The notional is a reference figure, not exchanged
Next Lesson
How Swap Payments Work — notional, the two legs, and netting. Next we run the numbers period by period and see why only the difference changes hands.