By the FinLingo Team | Capital markets practitioner, front office experience at a major European investment bank. FinLingo covers 342 lessons from bonds to exotic derivatives. About · Last updated:
A swap is a derivative contract where two parties agree to exchange cash flows over a period of time. The most common type is an interest rate swap (IRS), where one party pays a fixed rate and receives a floating rate (like SOFR or EURIBOR), while the other does the opposite. No principal changes hands — only the net difference in interest payments.
Consider a 5-year swap on $10 million notional. Party A pays fixed at 3.5% per year and receives 3-month SOFR. Party B does the reverse. Every quarter, the two sides compare: if SOFR is at 4.0%, Party B pays A the net difference of 0.5% on $10 million for that quarter — roughly $12,500. If SOFR drops to 3.0%, Party A pays B roughly $12,500. The swap converts Party A's floating-rate exposure into a fixed obligation.
At inception, the swap has zero value — neither party pays the other upfront. The fixed rate that makes this true is called the par swap rate. It is determined by the current yield curve: the fixed rate equals the present value of expected floating payments. After inception, as rates move, the swap develops positive value for one side and negative for the other.
A corporation with floating-rate debt can swap to fixed, eliminating interest rate uncertainty. A bank with fixed-rate mortgages can swap to floating, matching its funding. Speculators can express views on the direction of rates without buying bonds. The interest rate swap market exceeds $400 trillion in notional — the single largest segment of the global derivatives market.
The value of an existing swap is the difference between the present value of its fixed leg and the present value of its floating leg: V = PV(fixed) − PV(floating) for the fixed-rate payer. Each leg is discounted using the current term structure of interest rates. If rates have risen since inception, the fixed-rate payer has a positive-value position (they locked in a below-market rate).
An interest rate swap is an agreement between two parties to exchange interest payments on a notional amount. One pays a fixed rate, the other pays a floating rate (like SOFR). No principal is exchanged. The net difference is settled periodically. It allows companies to convert floating-rate debt to fixed, or vice versa.
To manage interest rate risk. A company with a floating-rate loan faces uncertainty about future payments. By entering a swap to pay fixed and receive floating, the company locks in a known cost. The floating payments received from the swap offset the floating payments on the loan, leaving only the fixed swap rate as the effective borrowing cost.
By computing the present value of each leg using the current yield curve. The value to the fixed-rate payer is PV(floating leg) minus PV(fixed leg). If rates have risen since the swap was created, the fixed payer benefits because they locked in a lower rate. The swap value changes with every move in the yield curve.
FinLingo covers swaps in Level 2 — 6 units from plain vanilla IRS to cross-currency swaps. Level 1 is free.
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