How do interest rate swaps work?

An interest rate swap is a derivative contract in which two counterparties agree to exchange interest payments on a specified notional principal amount. In the most common form, called a "plain vanilla" swap, one party pays a fixed rate while the other pays a floating rate tied to a benchmark like SOFR. The notional principal is never actually exchanged; it simply determines the size of the interest payments.

Consider a corporation that has issued floating-rate debt but wants predictable interest costs. It enters a swap where it pays a fixed rate of 4% and receives SOFR. The SOFR payments it receives from the swap offset its floating-rate debt payments, effectively converting its liability into a fixed rate. Conversely, a pension fund holding fixed-rate bonds might enter the opposite side of a swap to gain floating-rate exposure. Each party manages its interest rate risk without changing its underlying assets or liabilities.

The interest rate swap market is the largest derivatives market in the world, with notional amounts outstanding exceeding $400 trillion globally. Swap rates are closely watched because they reflect market expectations for future interest rates and credit conditions. The spread between swap rates and Treasury yields (the "swap spread") captures perceived banking system credit risk and supply-demand dynamics in the government bond market. Negative swap spreads, which have persisted in long maturities, indicate unusual demand for Treasuries relative to swaps.

Central clearing through institutions like the London Clearing House (LCH) has reduced counterparty risk in the swap market since the 2008 financial crisis. Regulators now require most standardized swaps to be centrally cleared and reported to swap data repositories. For market participants, swap rates serve as both hedging tools and informational benchmarks, revealing how the market prices the path of interest rates over horizons ranging from one year to thirty years.