Swap Rates
A comprehensive introduction to interest rate swaps, how they work, and how they are priced
What Is an Interest Rate Swap?
An interest rate swap is a financial derivative contract where two parties agree to exchange interest rate payments over a set period. The most common type is a vanilla interest rate swap, where one party pays a fixed rate and receives a floating rate, while the other party does the opposite.
Fixed Rate (e.g., 3.5%)
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Floating Rate (e.g., SOFR + spread)Key characteristics:
No exchange of principal — only interest payments are swapped
Payments are typically netted (only the difference is paid)
The notional amount is used only for calculating interest
Why Use Interest Rate Swaps?
1. Hedging Interest Rate Risk
The most common use case. A borrower with a floating-rate loan can enter a swap to effectively convert it to a fixed rate, protecting against rising interest rates.
Example: A company borrows €50M at EURIBOR + 2%. They're exposed to EURIBOR fluctuations. By entering a swap where they pay fixed and receive EURIBOR, they lock in their total borrowing cost.
2. Speculation
Traders can take positions on the direction of interest rates without borrowing or lending actual funds.
3. Arbitrage
Exploiting pricing differences between markets or instruments.
The Two Legs of a Swap
An interest rate swap consists of two sets of cashflows:
The Fixed Leg
Pays a fixed interest rate (the "swap rate") on the notional amount
Rate is determined at the start of the contract and remains constant
Typically paid annually or semi-annually
The Floating Leg
Pays a variable interest rate based on a reference index
Common indices: SOFR (USD), SONIA (GBP), EURIBOR (EUR), ESTR (EUR OIS)
Rate resets periodically (e.g., every 3 or 6 months)
Often includes a spread over the index
Payment Schedule Example (5-Year Swap):
Fixed Leg (Annual)
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Floating Leg (Quarterly)
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The fixed leg pays once per year at a rate locked in at inception. The floating leg pays quarterly, with the rate resetting each period based on the reference index.
How Is the Swap Rate Determined?
At inception, a swap is priced so that the present value of both legs is equal — meaning the swap has zero value to both parties (before any spreads are added).
The fixed rate that satisfies this equation is called the par swap rate or mid-rate.
What Drives Swap Rates?
Forward rate expectations — Market expectations of future floating rates
Supply and demand — Hedging activity and speculative positioning
Credit conditions — Interbank lending conditions affect swap spreads
Breaking Down the Swap Rate
When you receive a swap quote from a bank, the rate typically includes three components:
Mid-Rate
The theoretical fair rate where PV(Fixed) = PV(Floating)
Execution Spread
Compensates the bank for market/liquidity risk when executing
Credit Spread
Compensates the bank for counterparty credit risk
Example: Hedging a Floating-Rate Loan
Scenario: A company has a €10M loan at 6M EURIBOR + 1.5% margin for 5 years.
Problem: If EURIBOR rises from 2% to 5%, their interest cost increases significantly.
Solution: Enter a 5-year interest rate swap:
Pay fixed: 2.58% (the current 5Y swap rate)
Receive floating: 6M EURIBOR
Result:
Pay to lender
EURIBOR + 1.5%
Pay on swap (fixed leg)
+ 2.58%
Receive on swap (floating leg)
− EURIBOR
Net borrowing cost
4.08%
How it works: The EURIBOR you receive from the swap offsets the EURIBOR you pay to the lender — these cancel out. What remains is:
The swap fixed rate (2.58%) — your new "base" interest cost
The loan margin (1.5%) — still paid to the lender on top
Total: 2.58% + 1.5% = 4.08% fixed, regardless of where EURIBOR moves.
Key Terminology
Notional
The principal amount used to calculate interest payments (not exchanged)
Tenor
The length of the swap (e.g., 5 years, 10 years)
Effective Date
When the swap starts accruing interest
Maturity Date
When the swap ends
Day Count Convention
Method for calculating interest (e.g., Actual/360, 30/360)
Payment Frequency
How often payments are made (e.g., quarterly, annually)
Mark-to-Market (MtM)
The current value of the swap based on market rates
Next Steps
Calculating a Swap Rate — Learn how to price a swap using BlueGamma
Calculating the MtM of a Swap — Value an existing swap position
Fetching a Swap Curve — Get swap rates via API
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