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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%)
        ┌─────────────────────────────────────────┐
        │                                         │
        ▼                                         │
   ┌─────────┐                              ┌─────────┐
   │  Party  │                              │  Party  │
   │    A    │                              │    B    │
   │(Borrower)│                             │ (Bank)  │
   └─────────┘                              └─────────┘
        │                                         ▲
        │                                         │
        └─────────────────────────────────────────┘
                 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):

Year 1
Year 2
Year 3
Year 4
Year 5

Fixed Leg (Annual)

●

●

●

●

●

Floating Leg (Quarterly)

● ● ● ●

● ● ● ●

● ● ● ●

● ● ● ●

● ● ● ●

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).

PV(Fixed Leg)=PV(Floating Leg)PV(\text{Fixed Leg}) = PV(\text{Floating Leg})

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:

Swap Rate=Mid-Rate+Execution Spread+Credit Spread\text{Swap Rate} = \text{Mid-Rate} + \text{Execution Spread} + \text{Credit Spread}

Component
Description

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

Pro Tip: Always request a breakdown of the swap rate into its components for full transparency. BlueGamma shows the mid-rate, so you can compare it against bank quotes to understand the total spread being charged.

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:

Cash Flow
Rate

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

Term
Definition

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

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