Interest Rate Swaps
The $500+ trillion derivatives market that underpins global finance.
How Pepsi Saved Millions (And Why You Should Care)
In 2019, Pepsi issued $1 billion in floating-rate debt. Their treasury team immediately entered an interest rate swap to convert it to fixed. Why? They wanted to lock in their borrowing costs and stop worrying about rate moves.
This is the world's largest derivatives market in action. Every day, corporations, banks, pension funds, and governments use interest rate swaps to manage their rate exposure. The notional outstanding exceeds $500 trillion-dwarfing equities, bonds, and every other market.
For rates traders, swaps aren't just hedging tools. They're the primary way to express views on interest rates. Want to bet rates will fall? Enter a receiver swap. Think rates will rise? Pay fixed. Unlike bonds, swaps require no upfront cash-just margin at your clearing house.
Key insight: Swaps let you take duration exposure without buying or selling bonds. You can be long or short billions of duration risk with just collateral-no balance sheet required.
What Is an Interest Rate Swap?
A swap is an agreement to exchange fixed interest payments for floating interest payments. No principal changes hands-the notional is just a reference amount for calculating payments.
Fixed Rate Payer
Pays fixed rate (e.g., 4.25%/year)
Believes rates will rise, wants floating exposure
Fixed Rate Receiver
Receives fixed rate (e.g., 4.25%/year)
Believes rates will fall, wants fixed exposure
Notional Principal
The reference amount (e.g., $100M). It's never exchanged-just used to calculate payments. This is why swaps are "off-balance sheet."
Floating Rate: SOFR
The floating leg resets periodically (usually quarterly) based on SOFR-the Secured Overnight Financing Rate. Before 2022, it was LIBOR.
Payment Frequency
Fixed leg typically pays semi-annually. Floating leg pays quarterly. Payments net against each other-only the difference changes hands.
Day Count Conventions
Fixed: 30/360. Floating: Actual/360. These conventions affect payment calculations-always check the details.
Swap Rates vs Treasury Yields
Swap rates and Treasury yields move together but aren't identical. The difference is called the swap spread:
Historically, swap spreads were positive (swaps yielded more than Treasuries). But since 2008, 30-year swap spreads have often been negative-a "broken" relationship that persists due to market structure.
Why Spreads Move
- Supply/demand imbalances: Heavy corporate hedging pushes rates up; dealer positioning matters
- Treasury supply: More Treasury issuance can widen spreads (or flip them negative)
- Credit conditions: Stress tightens spreads as banks need to pay up for fixed
- Regulation: Bank capital rules affect dealer willingness to intermediate
Trading Swap Spreads
- Long spread: Receive fixed in swap + short Treasury. Profits if spread widens.
- Short spread: Pay fixed in swap + long Treasury. Profits if spread tightens.
- Risk: Spreads can move 20-50bps quickly. Duration-neutral doesn't mean risk-free.
Historical Swap Spread Blowouts
Swap spreads have caused some of the biggest surprises in rates markets. Study these events:
30Y Swap Spread Goes Negative
Spread: -30bpsThe Setup
During the height of the financial crisis, 30-year swap spreads went deeply negative for the first time in history. This meant swap rates were LOWER than Treasury yields-theoretically impossible since Treasuries are "risk-free" and swaps carry counterparty risk.
What Happened
Dealers were forced to receive fixed in swaps to hedge their corporate bond inventories. Simultaneously, Treasury supply exploded as the government funded bailouts. The "impossible" happened: you got paid more to lend to the government than to receive fixed in a swap.
DV01 and Duration of Swaps
Swaps have interest rate risk just like bonds. The key insight: a swap is equivalent to a bond position from a duration perspective.
Receiver Swap
Receive Fixed, Pay Floating
Like owning a fixed-rate bond. You benefit when rates fall (the fixed payments you receive become more valuable). A 10Y receiver swap has ~10 years of duration.
Payer Swap
Pay Fixed, Receive Floating
Like shorting a fixed-rate bond. You benefit when rates rise (the fixed payments you make become less valuable vs market rates). A 10Y payer swap has ~-10 years of duration.
DV01 Comparison
For $100M notional, approximate DV01 by tenor:
DV01 = Duration x Notional / 10,000. A receiver profits this amount per 1bp rate fall.
Build a Swap-Based Position
Trade Legs
Combined Position
Payoff Profile
P&L across parallel yield curve shifts (all tenors move equally):
Risk Summary
Position is long duration (+$81K DV01). Profits when rates fall, loses when rates rise.
Trade Examples (Simple)
Here are three common swap trades explained simply:
The Receiver Swap: "Rates Will Fall"
You enter a $100M 10-year receiver swap at 4.25% fixed rate. You'll receive 4.25% fixed and pay SOFR floating.
No upfront cash required-just post margin at the clearing house (~$2-5M for this size). Your "investment" is the collateral, not the notional. This is why swaps are so capital efficient. You're getting $100M of duration exposure for a fraction of the cash needed to buy $100M of bonds.
Rates fall 50bps across the curve.
50bps x $100,000 DV01 = +$5,000,000 mark-to-market gain
You locked in receiving 4.25% when rates were higher. Now new swaps only offer 3.75%. Your swap is worth more because you're getting above-market fixed payments. Pure duration bet-no funding costs, no carry bleed.
The Payer Swap: "Rates Will Rise"
You enter a $100M 10-year payer swap at 4.25% fixed. You'll pay 4.25% fixed and receive SOFR floating.
Same margin requirement as a receiver. The difference: you're now SHORT duration. As rates rise, your fixed payment obligation becomes less onerous relative to market rates. Think of it as synthetic bond short without the hassle of locating and borrowing securities.
Rates rise 50bps.
50bps x $100,000 DV01 = +$5,000,000 mark-to-market gain
You're paying 4.25% but new swaps require 4.75%. Someone would pay to take over your obligation to pay only 4.25%. That's your profit. You got short duration without shorting bonds.
The Asset Swap: "Convert Bond to Floating"
You buy a $100M 10Y corporate bond yielding 5.5%. Simultaneously, you pay fixed in a 10Y swap at 4.25%.
Bond is financed in repo (say 5.30% GC). The swap converts your fixed coupons to floating. Net result: you earn the credit spread (5.5% - 4.25% = 125bps) over SOFR, with minimal duration risk. The bond's fixed coupons "pay" the swap's fixed leg.
Rates move 50bps. You don't care much.
Bond loses/gains from rates, swap gains/loses the opposite. Net duration: ~zero. You're earning the credit spread with hedged rate risk.
You isolated the corporate credit spread from rate risk. The bond pays you 5.5%, you pass on 4.25% to the swap, keeping 1.25% + SOFR. If you believe in the credit but not the rate view, this is how you trade it.
Swaps vs Bonds: Key Differences
No Repo Needed
This is huge. Bond positions require repo financing-borrowing against the bond to fund the purchase. Repo markets can seize up, rates can spike, and specials can move against you.
Swaps bypass all of that. You just post margin (cash or Treasuries) at the clearing house. No overnight funding rollovers, no repo fails, no special rates. Your "funding cost" is the margin you post, which earns interest.
For many traders, swaps are the preferred way to express rate views precisely because they avoid the funding complexities of cash bonds.