# Swap Rates

## 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).

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

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:

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

| 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             |

{% hint style="info" %}
**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.
{% endhint %}

***

## 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

* [Calculating a Swap Rate](/documentation/pricers/calculating-a-swap-rate.md) — Learn how to price a swap using BlueGamma
* [Calculating the MtM of a Swap](/documentation/pricers/calculating-the-mtm-of-a-swap.md) — Value an existing swap position
* [Fetching a Swap Curve](/documentation/integrations/api/how-to-guides/fetching-a-swap-curve.md) — Get swap rates via API


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