Many interest rates in the market are variable and tied to financial benchmarks, making them subject to frequent fluctuations. These changes can significantly affect a company’s or investor’s cash flow or borrowing costs. As such, many institutions use interest rate swaps—financial contracts between two parties to exchange interest payments over a specified period. These tools are commonly used to match financing streams with an entity’s risk preferences or expectations about interest rate movements.
In this article, Realized 1031 dives deeper into the interest rate swap definition to help you understand this practice and determine if it’s a suitable approach for your current situation. Let’s take a closer look.
An interest rate swap is a financial contract in which two parties agree to exchange one stream of interest payments for another, based on a specified notional amount, over a set period. Why a swap, then? The term “swap” reflects the core idea of this strategy: each party “swaps” its interest rate exposure with the other to achieve a financial objective, such as stabilizing cash flows or managing interest expense.
Interest rate swaps are a type of forward contract, forward referring to the fact that the agreements made today are for transactions that will occur in the future. These contracts allow investors and businesses to hedge against anticipated changes in interest rates, lock in fixed payments to match liabilities, or transition between floating and fixed-rate structures.
During an interest rate swap, one party agrees to pay a fixed interest rate while the other pays a floating (or variable) rate. Variable rates are typically linked to widely used financial benchmarks such as the Secured Overnight Financing Rate (SOFR), which reflects the general cost of overnight borrowing. (Note: SOFR has largely replaced LIBOR as the dominant reference rate following its phase-out.)
Importantly, the principal amount is not actually exchanged between the parties. The notional amount is used solely to calculate the interest payments due under the swap.
There are three common methods for swapping interest rates.
This is the type we mentioned above. The fixed-to-floating swap is one of the most common types of interest rate swaps used for hedging interest-rate exposure and is often referred to as a vanilla swap due to its standardized structure. In this arrangement, one party pays a fixed interest rate, while the other pays a floating rate based on a benchmark index. and is considered to be the easiest and most straightforward. Use Case
Company A, with a fixed-rate debt, believes that interest rates are about to go down. Entering a fixed-to-floating swap may allow the company to benefit from lower rates and potentially reduce interest expense—assuming rates fall as expected.
On the other hand, the floating-to-fixed swap serves as the exact opposite of the first variation. A company exchanges its variable interest rate for the fixed rate of another entity.
A business with floating-rate debt worried about rising interest rates might use this type of swap to lock in predictable, stable payments. The swap is often used as a hedging strategy against rising rates. What benefit would this provide to the company that originally had the fixed rate? They might believe that interest rates will actually go down in the future, so they will take the risk.
Also called a basis swap, this strategy entails both parties with variable interest rates swapping. Both parties exchange variable interest payments, each tied to a different benchmark. While SOFR (Secured Overnight Financing Rate) and historically, LIBOR (now phased out for new contracts) have traditionally been used, other benchmarks may apply.
Basis swaps are usually applied when institutions want to hedge basis risk, or the risk that two interest rate indexes will move differently. These are frequently seen in international finance, where different regions may use different benchmarks.
Swapping two fixed-rate streams is uncommon in domestic markets because it does not address interest rate uncertainty. However, this approach may be used in cross-currency swaps, where each fixed rate is denominated in a different currency. These contracts are used by companies operating in multiple jurisdictions to manage foreign exchange and interest rate exposure simultaneously.
Let’s say Company A has a $10 million loan with a floating interest rate of SOFR + 2%. Based on recent trends, Company A is concerned that interest rates might rise, which would increase its borrowing costs.
On the other hand, Company B has a $10 million loan with a fixed interest rate of 5%, but they expect rates to drop and want to benefit from lower floating rates.
Both negotiate to do a floating-to-fixed interest rate swap.
Company A takes on the fixed interest rate of 5% to hedge itself against the possible increase. Meanwhile, Company B pays Company A’s SOFR + 2% rates. The notional principal for calculating payments in this swap is $10 million, but no actual principal is exchanged. The swap is executed as a separate contractual agreement, typically governed by an ISDA Master Agreement, and does not change the terms of the original loans.
This question is a common concern among investors and business owners. Interest rate swaps are generally over-the-counter (OTC) derivatives. These agreements are traded directly between parties rather than through an exchange.
However, following the 2008 financial crisis, regulators introduced significant regulatory oversight of the swaps market— particularly in the U.S. under the Dodd-Frank Act. Certain standardized swaps must now be cleared through central counterparties (CCPs) and reported to swap data repositories to enhance market transparency and reduce systemic risk.
While many custom or highly structured swaps remain privately negotiated, they are still subject to CFTC regulation, including reporting, recordkeeping, and, in some cases, margin and capital requirements. These rules aim to address both counterparty credit risk and broader financial system stability.
Counterparty risk remains a central consideration in OTC swaps, particularly for bespoke agreements not cleared through a central counterparty. Regulatory oversight has helped reduce, but not eliminate, these exposures.
The primary reason companies and investors perform interest rate swaps is to hedge against interest rate fluctuations. Swaps help manage interest rate exposure by enabling parties to lock in fixed payments or gain exposure to floating rates based on market expectations. This flexibility can help reduce uncertainty around future borrowing costs.
One potential benefit is the lower borrowing costs. For example, a company with a strong credit rating may issue fixed-rate debt at a favorable rate, while another may find floating-rate debt more accessible. By entering into a swap, both parties may improve the structure of their financing, potentially resulting in lower net interest expense compared to issuing or holding debt outright.
Swaps can also provide customization. A well-structured swap allows a company to match its interest payments to its revenue stream, debt obligations, or broader financial strategy. This alignment may support stronger risk management and better liquidity forecasting.
These benefits rely on careful structuring and market timing; incorrect expectations (e.g., if rates move opposite to projections) can offset intended gains. Swaps don't eliminate risk—they transfer it, introducing counterparty exposure and potential liquidity challenges.
Risks of Interest Rate Swaps
While interest rate swaps offer flexibility and strategic benefits, they also carry a number of risks that must be carefully evaluated:
Because of these risks, interest rate swaps are generally used by sophisticated investors, institutions, or companies with access to derivative risk management expertise.
Leveraging interest rate swaps may be a useful strategy for investors and businesses who are facing uncertainty with their debts. Whether you’re going for a floating-to-fixed, fixed-to-floating, or floating-to-floating approach, these instruments can potentially help address interest rate exposure without requiring the refinancing of underlying debt. However, swaps are complex financial products and carry risks, including market risk, counterparty risk, and regulatory obligations. Before entering the interest rate swap market, it's strongly recommended to consult with a qualified financial advisor or derivatives professional to evaluate the risks, understand the structure, and determine whether a swap aligns with your specific financial objectives.
The tax and estate planning information offered by the advisor is general in nature. It is provided for informational purposes only and should not be construed as legal or tax advice. Always consult an attorney or tax professional regarding your specific legal or tax situation.
Article written by: Story Amplify. Story Amplify is a marketing agency that offers services such as copywriting across industries, including financial services, real estate investment services, and miscellaneous small businesses.
Sources:
https://www.investopedia.com/terms/i/interestrateswap.asp
https://www.investopedia.com/terms/l/libor.asp
https://www.newyorkfed.org/markets/reference-rates/sofr
https://www.investopedia.com/terms/f/fixed_floatswap.asp
https://www.investopedia.com/terms/b/basisrateswap.asp
https://www.investopedia.com/terms/d/dodd-frank-financial-regulatory-reform-bill.asp