Interest Rate Swap

Each leg accrues interest on the same notional over matching accrual periods, but the two legs are rarely symmetric in their conventions. The fixed leg typically accrues on a 30/360 or actual/365 basis and may pay annually or semiannually; the floating leg follows an actual/360 convention and pays at the frequency of its reference rate. On each payment date the two accrued amounts are compared and only the difference changes hands, so a party owing 4.20 percent fixed while receiving 4.55 percent floating on a stated notional receives the 0.35 percent differential for that period.

Timing matters. In a traditional swap the floating rate is observed at the start of a period and paid at its end, known as advanced set, settled in arrears. Compounded overnight rates such as SOFR are instead observed across the period and known only near payment, which is why modern contracts specify observation shifts and lockout periods.

A swap is priced, not purchased: the fixed rate is chosen so the present values of the two legs are equal, giving the contract zero value to both sides at inception. Because the floating leg, valued at a reset date, is worth par plus the imminent coupon, the condition reduces to a simple statement. The par swap rate per period equals one minus the discount factor for the final payment date, divided by the sum of the discount factors for all payment dates, with the result annualised by the payment frequency.

Economically that rate is a discount-factor-weighted average of the forward rates implied by the current curve. It follows that an upward-sloping curve produces a fixed rate above the current short rate, so a pay-fixed party expects to pay away cash early in the swap's life and recover it later if forwards are realised.

Once rates move, the swap acquires value. The standard approach treats it as a long position in one bond and a short position in another: the receive-fixed party holds a synthetic fixed-rate bond financed by a synthetic floating-rate note. Value equals the present value of the remaining fixed payments, discounted on the current curve, minus the value of the floating leg, which resets to par on each reset date. An equivalent method computes the difference between the original fixed rate and the current par rate for the remaining tenor, multiplied by notional and by the sum of the remaining discount factors, the annuity factor.

Duration follows directly. A pay-fixed swap carries negative duration and gains when rates rise; a receive-fixed swap behaves like owning a bond. This is why asset managers use swap overlays to adjust portfolio duration without trading the underlying securities.

Standardised interest rate swaps in major currencies are now largely cleared through central counterparties under post-crisis mandates, with initial and variation margin replacing much of the bilateral credit exposure that once made counterparty quality a pricing input. Remaining bilateral trades sit under an ISDA Master Agreement with a credit support annex governing collateral. Quoted swap rates across tenors form the swap curve, a primary benchmark for corporate loan pricing and a reference against which government bond yields are measured as the swap spread.

Users include banks converting fixed-rate mortgage assets into floating exposure to match deposit funding, corporates locking in borrowing costs ahead of an issue, and pension funds receiving fixed to extend liability-matching duration. Candidates should be able to derive a par rate from discount factors, value a seasoned position, and state the direction of exposure each leg creates.