The interest rate swap is the most traded financial instrument in the world. The notional value of outstanding interest rate swaps runs into hundreds of trillions of dollars. Yet despite this scale, the concept is remarkably straightforward: two parties agree to exchange interest payments on the same notional principal, one paying a fixed rate and the other paying a floating rate. No principal changes hands. The swap is purely a mechanism for converting one interest rate exposure into another.
Why would anyone want a swap?
Consider two scenarios. A corporate treasurer has issued five years of floating-rate debt (say, SOFR + 1.5%). She is worried rates will rise and wants the certainty of a fixed payment. By entering a swap — paying fixed, receiving floating — the floating payments she receives on the swap offset the floating payments on her debt, leaving her with a net fixed rate. She has synthetically converted her floating-rate liability into a fixed-rate liability without refinancing.
The same logic applies in reverse: a bank holds a large portfolio of long-duration fixed-rate mortgages (assets) but funds itself with short-term floating-rate deposits (liabilities). It is exposed to falling rates — if rates fall, its asset income falls but its liability costs remain market-driven. By entering a swap paying fixed and receiving floating, it hedges this mismatch.
The yield curve and swap rates
Swap rates for different maturities — 1y, 2y, 5y, 10y, 30y — constitute the swap curve, which is closely watched by markets as a benchmark for interest rate expectations. The swap curve is distinct from but highly correlated with the government bond curve. It reflects the market's consensus view of where short-term floating rates (which track central bank policy) will average over each maturity horizon. When the swap curve inverts — meaning 2-year swap rates are higher than 10-year swap rates — it signals that markets expect the central bank to cut rates significantly over the coming decade.
Duration, DV01, and swap hedging
A swap has interest rate sensitivity: as rates move, the market value of the swap changes. This sensitivity is measured by DV01 (dollar value of a basis point) — the change in the swap's mark-to-market value for a one basis point move in rates. A 10-year swap on $100 million notional might have a DV01 of ~$85,000: for every basis point rates move, the swap gains or loses $85,000 in value to the fixed payer. Traders and risk managers use DV01 to aggregate and hedge interest rate exposure across entire books of swaps, bonds, and other rate-sensitive instruments.