Plain-Vanilla Interest Rate Swaps Mechanics
Plain-Vanilla Interest Rate Swaps Mechanics
A plain-vanilla interest rate swap is an agreement between two parties to exchange fixed-rate interest payments for floating-rate interest payments over a specified period. These swaps are the most common OTC derivative instrument, used extensively for hedging interest rate risk and adjusting portfolio duration.
Definition and Key Concepts
Core Structure
An interest rate swap involves two counterparties:
- Fixed-rate payer: Pays a predetermined fixed rate and receives floating rate
- Floating-rate payer: Pays a variable rate (tied to a benchmark) and receives fixed rate
Key terms:
| Term | Definition |
|---|---|
| Notional principal | Reference amount for calculating payments (not exchanged) |
| Fixed rate | Predetermined rate agreed at inception |
| Floating rate | Variable rate reset periodically (SOFR, EURIBOR) |
| Tenor | Total duration of the swap |
| Payment frequency | How often payments are exchanged |
| Day count convention | Method for calculating interest accrual |
Reference Rates
Following LIBOR transition, common floating benchmarks include:
| Currency | Benchmark | Administrator |
|---|---|---|
| USD | SOFR | Federal Reserve |
| EUR | EURIBOR / €STR | EMMI / ECB |
| GBP | SONIA | Bank of England |
| JPY | TONA | Bank of Japan |
| CHF | SARON | SIX |
Day Count Conventions
| Convention | Calculation | Common Use |
|---|---|---|
| Actual/360 | Actual days / 360 | USD floating |
| Actual/365 | Actual days / 365 | GBP fixed |
| 30/360 | Assumes 30-day months | USD fixed |
| Actual/Actual | Actual days / actual year | Bonds |
How It Works in Practice
Payment Calculation
Fixed leg payment: Fixed Payment = Notional × Fixed Rate × (Days in Period / Day Count Basis)
Floating leg payment: Floating Payment = Notional × Floating Rate × (Days in Period / Day Count Basis)
Net payment: Only the difference between fixed and floating payments changes hands.
Cash Flow Timing
Typical schedule for a 5-year USD swap:
| Event | Timing |
|---|---|
| Trade date | T+0 |
| Effective date | T+2 |
| First fixing | Effective date |
| First payment | 3 or 6 months after effective date |
| Subsequent payments | Quarterly or semi-annually |
| Maturity | 5 years from effective date |
Payment netting: On each payment date, the party owing the larger amount pays the net difference to the other party.
Market Conventions
Standard terms for USD interest rate swaps:
| Feature | Convention |
|---|---|
| Fixed leg frequency | Semi-annual |
| Floating leg frequency | Quarterly (SOFR) |
| Fixed day count | 30/360 |
| Floating day count | Actual/360 |
| Business day convention | Modified Following |
| Holiday calendar | New York |
Worked Example
Trade details:
- Notional: $100 million
- Tenor: 5 years
- Fixed rate: 4.25% (semi-annual, 30/360)
- Floating rate: 3-month SOFR + 0 bps (quarterly, Actual/360)
- Counterparty A: Pays fixed, receives floating
- Counterparty B: Pays floating, receives fixed
First payment period (6 months, fixed leg): Fixed Payment = $100,000,000 × 4.25% × (180/360) Fixed Payment = $100,000,000 × 0.0425 × 0.5 Fixed Payment = $2,125,000
First quarter (floating leg, 91 days, SOFR = 4.50%): Q1 Floating = $100,000,000 × 4.50% × (91/360) Q1 Floating = $100,000,000 × 0.045 × 0.2528 Q1 Floating = $1,137,500
Second quarter (floating leg, 92 days, SOFR = 4.35%): Q2 Floating = $100,000,000 × 4.35% × (92/360) Q2 Floating = $100,000,000 × 0.0435 × 0.2556 Q2 Floating = $1,111,700
Total floating for semi-annual period: Total Floating = $1,137,500 + $1,111,700 = $2,249,200
Net payment: Counterparty A (fixed payer) receives: $2,249,200 - $2,125,000 = $124,200
Because floating rates exceeded the fixed rate, the fixed-rate payer receives a net payment.
Payment Schedule Summary
| Period | Fixed Payment | Floating Payment | Net to Fixed Payer |
|---|---|---|---|
| 6M | $2,125,000 | $2,249,200 | +$124,200 |
| 12M | $2,125,000 | $2,180,500 | +$55,500 |
| 18M | $2,125,000 | $2,050,800 | -$74,200 |
| 24M | $2,125,000 | $1,985,600 | -$139,400 |
Net payments vary each period based on floating rate movements.
Risks, Limitations, and Tradeoffs
Interest Rate Risk
The mark-to-market value of a swap changes with interest rate movements:
| Rate Movement | Fixed Payer Impact | Floating Payer Impact |
|---|---|---|
| Rates rise | Gain (receives more floating) | Loss (pays more) |
| Rates fall | Loss (receives less floating) | Gain (pays less) |
DV01 (Dollar Value of 01): A $100 million 5-year swap has approximately $45,000 DV01—meaning a 1 basis point parallel shift changes the swap's value by $45,000.
Counterparty Credit Risk
Exposure considerations:
- Exposure grows as rates move in your favor
- Maximum exposure typically occurs mid-life of the swap
- Cleared swaps mitigate counterparty risk through CCP guarantee
Basis Risk
If the floating index differs from your actual funding cost, basis risk arises. SOFR may not perfectly match your borrowing rate.
Common Pitfalls
| Pitfall | Description | Prevention |
|---|---|---|
| Day count mismatch | Different conventions create P/L leakage | Verify all day counts at trade inception |
| Fixing date errors | Wrong observation dates for floating rate | Confirm fixing calendar and lag |
| Holiday misalignment | Payment dates falling on holidays | Agree on business day conventions |
| Notional mismatch | Intended amount differs from booked | Reconcile term sheets before execution |
Checklist and Next Steps
Pre-trade checklist:
- Confirm notional amount and tenor
- Verify fixed rate and payment frequency
- Confirm floating rate index and spread
- Check day count conventions for both legs
- Review business day conventions
- Confirm payment netting arrangements
- Verify collateral terms (CSA thresholds, eligible collateral)
- Ensure ISDA documentation is in place
Post-trade checklist:
- Verify trade confirmation matches term sheet
- Set up rate fixings in systems
- Schedule payment dates
- Establish collateral monitoring
- Report to trade repository (if required)
Related articles:
- For cross-currency mechanics, see Cross-Currency Swaps and Basis Risk
- For collateral terms, see Credit Support Annex and Collateral Terms