Swap

Every swap has two legs, each a defined stream of payments computed on the same notional. In the standard interest rate swap one leg is fixed at the swap rate agreed at inception and the other floats with a reference rate such as SOFR or EURIBOR. The floating rate is typically observed at the start of each period and paid at the end, so each payment is known one period in advance. Payment amounts are the rate multiplied by the notional and by a day count fraction, so quarterly and semi-annual legs of the same swap can differ in frequency and convention.

Because both legs are denominated in the same currency in a plain vanilla swap, only the difference changes hands on each date. If the floating rate for a period exceeds the fixed rate, the fixed-rate payer receives the net amount; if it falls below, the fixed-rate payer sends it. This netting is what keeps credit exposure small relative to the size of the notional.

The swap rate is not a forecast chosen by one side; it is the rate that equates the present value of the two legs on trade date. Conceptually, discount factors are taken from the relevant curve, the expected floating payments are valued, and the fixed rate is solved so the fixed leg has the same present value. The result is a weighted average of the implied forward rates across the swap's payment schedule, which is why a swap can be read as a strip of forwards struck at one common rate rather than at each forward's own rate.

After inception the swap no longer has zero value. If the curve rises, the expected floating receipts increase and the pay-fixed position gains, while the receive-fixed position loses by an equal amount. An equivalent framing is that a receive-fixed swap behaves like being long a fixed-coupon bond and short a floating-rate note of the same notional, which explains why its market value carries positive duration.

Interest rate swaps are the largest single segment of the OTC derivatives market by notional and form the backbone of institutional rate risk management. A corporate issuer with floating-rate bank debt can pay fixed and receive floating to lock its funding cost; a bank with fixed-rate mortgage assets can do the reverse to reduce asset-liability mismatch. Beyond rates, currency swaps exchange payment streams in two currencies, equity swaps convert an index or single-stock return into a financing rate, and total return swaps let investors take credit or asset exposure without owning the asset.

Since the post-crisis reforms, standardised swaps in major currencies are largely traded on regulated venues and cleared through central counterparties with daily variation margin, which sharply reduces bilateral counterparty risk. Under IFRS and US GAAP the swap sits on the balance sheet at fair value, with hedge accounting determining whether fair value changes flow through profit or loss or through other comprehensive income.

Three skills recur. First, identify the direction of exposure: the pay-fixed side gains when rates rise and is the natural hedge for floating-rate borrowing, while the receive-fixed side gains when rates fall. Second, compute a single net settlement: apply the fixed and floating rates to the notional, adjust each by its day count fraction, and take the difference, remembering that the floating rate was set at the beginning of the period being paid.

Third, place the swap correctly among related instruments. A swap is customisable, negotiated with a dealer, and periodic; a futures contract is standardised, exchange-traded and margined daily; an FRA is a single-period forward on a reference rate. Candidates should also recognise that mid-life value, not the notional, measures credit exposure, and that valuing a swap means discounting the remaining legs on the current curve.