Interest Rate Swap
A derivative contract in which two parties exchange interest payments on a notional amount — one paying a fixed rate, the other paying a floating rate — the most widely traded derivative in the world.
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What Is an Interest Rate Swap?
An interest rate swap (IRS) is an agreement between two parties to exchange interest rate cash flows over a set period on a notional principal amount (which itself is never exchanged). In the most common "plain vanilla" swap:
- Party A pays a fixed rate (the "swap rate")
- Party B pays a floating rate (typically tied to SOFR or previously LIBOR)
Example: Company A has issued floating-rate debt (SOFR + 200bps) but wants certainty about its interest costs. It enters a swap, paying fixed 4.5% to Bank B and receiving SOFR. Net result: Company A pays 4.5% + 200bps = 6.5% total — now fixed.
The Swap Market
The global IRS market has a notional outstanding of over $400 trillion — by far the largest derivatives market. The primary participants are:
- Banks and dealers: Market-making and managing their own interest rate exposure
- Corporations: Hedging debt costs
- Pension funds and insurance companies: Matching long-duration liabilities
- Governments: Some sovereigns use swaps to manage debt profiles
- Hedge funds: Speculative positioning on rate direction
Swap Spreads
The swap spread is the difference between the swap rate and the yield on a Treasury of the same maturity. In theory, swap rates should be above Treasury yields (reflecting bank credit risk in the swap). However, in 2019–2020, US swap spreads turned negative — Treasuries yielded more than swaps — a sign of systemic dysfunction and dealer balance sheet constraints.
Overnight Indexed Swaps (OIS)
An Overnight Indexed Swap exchanges a fixed rate for the daily compounded SOFR (overnight) rate. The OIS rate is the market's expectation of the average overnight rate over the swap's life — a cleaner measure of rate expectations than Treasury yields. The OIS-LIBOR spread (now OIS-SOFR spread) is a key funding stress indicator.
What to Watch
- 5y and 10y swap rates: Market-implied expectations for medium-term rates
- Swap spreads: Negative spreads signal Treasury supply pressure or dealer balance sheet stress
- SOFR-OIS spread: Indicator of short-term funding market stress
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