Guide

Interest rate swaps explained

Harbor Capital issued $250M of ten-year fixed-rate notes at 4.85% to fund a leveraged loan sleeve, then watched the yield curve invert: five-year swap rates fell 90 bp while their coupon stayed locked. Treasury asked for a liability hedge that converted fixed debt into synthetic floating without refinancing covenants. The desk entered a receive-fixed / pay-floating interest rate swap (IRS) on $200M notional at 4.72% fixed versus compounded SOFR + 0 bp, collateralized under a two-way CSA with a G-SIB dealer. All-in funding cost became SOFR + 13 bp (spread over the floating leg) instead of 4.85% fixed — a bet that short rates would stay elevated while long-end rates fell. When SOFR dropped 75 bp over the next year, the swap gained $14.2M mark-to-market while the bond’s fixed coupon looked expensive on a relative-value screen. That outcome only makes sense if you understand what swaps actually exchange, how they are valued, and why post-LIBOR conventions matter.

An interest rate swap is a contract between two parties to exchange periodic interest payments on a agreed notional amount without exchanging principal. The dominant flavor is fixed-for-floating: one leg pays a fixed coupon; the other pays a floating rate tied to a benchmark such as SOFR, Term SOFR, or (legacy) LIBOR. Swaps are the workhorse of corporate hedging, bank asset-liability management, and the construction of duration positions. This guide covers leg mechanics and net settlement, swap curves and par rates, DV01 sizing, OIS discounting, SOFR compounding conventions, CSA collateral, the Harbor Capital liability hedge refactor, a technique decision table against FRNs and futures, pitfalls, and a production checklist alongside policy rate and money-market plumbing.

Fixed-for-floating mechanics

In a plain-vanilla USD IRS, counterparties agree on:

Notional — the reference principal (e.g. $200M). No principal changes hands; it scales cash flows only.
Fixed leg — pays coupon = notional × fixed rate × day-count fraction each period (typically semi-annual, 30/360 or ACT/360).
Floating leg — pays notional × (benchmark + spread) × day-count fraction, reset each period from published fixings.
Tenor — total maturity (2Y, 5Y, 10Y, 30Y are liquid points on the swap curve).
Net settlement — only the difference between legs is paid; the party owed the larger amount receives the net.

A corporate that issued fixed-rate debt and wants floating exposure enters pay-fixed / receive-floating: it pays the swap’s fixed coupon and receives SOFR (or Term SOFR). Economically, fixed bond coupon + pay-fixed swap ≈ floating funding at SOFR + spread. An asset manager holding floating-rate loans who fears rate cuts enters receive-fixed / pay-floating to lock income.

Swaps are traded over-the-counter (OTC) with ISDA documentation. Standard schedules use modified following business-day conventions and two-day payment lags after period end. Unlike exchange-traded futures, each trade can be customized — but liquidity concentrates at standard tenors and IMM roll dates.

Swap curves, par rates and valuation

The swap curve plots par swap rates by tenor — the fixed rate that makes a new swap’s present value zero at inception. Market makers quote “10Y at 4.72 / 4.74” meaning bid/offer on the fixed leg versus standard floating conventions. The curve embeds expectations for future short rates plus term premia; it often diverges from the Treasury curve because swap rates reflect bank credit and funding spreads (the “swap spread” over Treasuries).

To value an existing swap, discount expected future net cash flows using an appropriate curve. Post-crisis practice discounts both legs with an overnight index swap (OIS) curve built from SOFR-OIS rates, not the old LIBOR discount curve. The fixed leg is a strip of zero-coupon bond cash flows; the floating leg, when discounted on OIS, is approximately par at each reset if the projection curve matches the discount curve — with convexity adjustments when they differ.

Risk metrics:

DV01 (dollar value of a basis point) — change in mark-to-market for a 1 bp parallel shift in the swap curve. A 10Y $100M pay-fixed swap might have DV01 around $8,000–$10,000 depending on rate level.
PV01 — sometimes used interchangeably with DV01; strictly, PV01 can refer to sensitivity of present value to a 1 bp move in a specific curve.
Key-rate DV01 — sensitivity to moves at 2Y, 5Y, 10Y etc., essential for barbell vs bullet hedges.

Swap marks move inversely to rate moves for the receive-fixed side: when rates rise, the fixed coupon you receive is worth less relative to market, so MTM falls. Pair swap DV01 with bond modified duration to size hedges that offset rate risk on both sides of the balance sheet.

SOFR conventions after LIBOR

USD LIBOR ceased publication for most tenors in 2023. New USD swaps float on SOFR with standardized compounding:

Compounded in arrears — daily SOFR is compounded over the coupon period; the rate is known only at period end (payment lag follows).
Lookback / observation shift — ISDA fallbacks use a five-day lookback so payers know amounts slightly before settlement.
Term SOFR — forward-looking fixings published by CME; some loan and swap products use Term SOFR + spread instead of compounded SOFR.

SOFR-OIS swaps (fixed vs compounded SOFR) define the risk-free discount and projection curve for valuing other swaps. The spread between Term SOFR and compounded SOFR (“term premium”) matters for corporate borrowers choosing loan index conventions. Legacy LIBOR swaps were converted via ISDA protocol to SOFR plus a spread adjustment (often ~26 bp for 3M LIBOR to SOFR) to preserve economic equivalence at transition.

Secured overnight rates like SOFR trade lower than old unsecured LIBOR; comparing all-in corporate funding costs requires adding credit spread on top of the floating index, not comparing raw fixings alone. See repo markets for where SOFR transactions originate.

Collateral, CVA and counterparty risk

OTC swaps expose each party to counterparty default before cash flows net out. A Credit Support Annex (CSA) requires daily margin when mark-to-market exceeds thresholds: the losing party posts cash or Treasuries. Two-way CSAs with zero threshold are standard between dealers; corporates often accept one-way posting (they post when out of the money, dealer posts when in their favor).

Credit valuation adjustment (CVA) and debit valuation adjustment (DVA) reflect the market price of counterparty credit risk in swap marks. For a corporate hedger, dealer selection and CSA terms can matter as much as the quoted spread. Central clearing through LCH or CME reduces bilateral exposure but adds initial margin and operational onboarding cost.

Harbor Capital liability hedge refactor (worked example)

Starting point — $250M 10Y fixed notes at 4.85%; duration ~7.8; CFO wants optional floating exposure without call provisions.
Objective — hedge $200M (80% of issue) to SOFR + 13 bp all-in; retain $50M unhedged as rate view.
Trade — pay-fixed 4.72% / receive compounded SOFR, semi-annual, 10Y, $200M notional, CSA with $500k threshold, G-SIB dealer.
Economics — bond pays 4.85% fixed; swap pays 4.72% fixed and receives SOFR; net fixed cost = 4.85% + 4.72% − SOFR on hedged notional ≈ SOFR + 13 bp on $200M plus 4.85% on remaining $50M.
DV01 match — swap DV01 ~$15,600/bp; bond DV01 ~$19,500/bp on full issue; 80% hedge covers ~64% of rate sensitivity (partial hedge by design).
12-month outcome — SOFR fell 75 bp; receive-fixed swap MTM +$14.2M; accounting treatment under hedge accounting (fair value hedge) offset bond mark losses on reporting dates.
Ops — daily CSA calls peaked at $2.1M variation margin; treasury held T-bill sleeve for liquidity.

They rejected a full refinancing into FRNs because call protection and investor relations favored keeping the original bond indenture; the swap achieved synthetic floating on most of the stack with reversible unwinds if the rate view changed.

Technique decision table

Approach	Best when	Trade-off
Plain-vanilla IRS	Transform fixed debt to floating (or vice versa) on known notional	OTC credit exposure; CSA liquidity; basis vs loan index
Issue FRN instead	New issuance; investors want floating paper natively	No MTM volatility; cannot retrofit existing fixed bonds
Short rate futures (SOFR/STIR)	Short-dated, liquid hedge; rolling exposure	Basis risk vs long bond duration; roll management
Treasury futures + CTD	Macro duration hedge on government portfolio	Cheapest-to-deliver basis; not a perfect corporate bond match
Interest rate cap/floor	Keep floating but limit upside (cap) or downside (floor)	Upfront premium; option decay
Swaption	Option to enter swap later; hedge future refinancing	Vol pricing; model risk on implied vol
Cross-currency swap	Foreign-currency funding with FX and rate exchange	FX basis; documentation complexity

Common pitfalls

Basis mismatch — hedging SOFR-based swap against fed funds-linked loans leaves spread risk when secured/unsecured spreads move.
Partial hedge drift — as the bond amortizes or duration shifts, DV01 match decays; rebalance or accept residual risk.
Discounting wrong curve — mixing LIBOR projection with OIS discount on legacy books post-transition breaks P&L explain.
Ignoring CSA liquidity — adverse rate moves can trigger large variation margin calls before MTM reverses.
Hedge accounting gaps — without documented effectiveness testing, swap MTM hits earnings while bond carrying value stays amortized cost.
Term SOFR vs compounded SOFR — loan pays one, swap pays the other; term premium becomes unhedged noise.
Dealer mark divergence — no exchange close; validate independent marks against CME cleared levels or multiple dealers.

Production checklist

Define economic objective: pay-fixed or receive-fixed; target all-in floating spread or locked fixed income.
Size notional and DV01 against underlying bond or loan portfolio; document partial vs full hedge rationale.
Confirm floating index (compounded SOFR, Term SOFR, fed funds) matches asset or liability index or quantify basis.
Negotiate CSA: threshold, minimum transfer, eligible collateral, haircuts.
Execute under ISDA Master + Schedule; confirm business-day and compounding conventions in confirmation.
Set up independent valuation (vendor curve + internal model) and daily MTM feed.
Stress test parallel and key-rate shifts; model CSA margin peaks.
If hedge accounting applies, document effectiveness method and regression tests.
Calendar fixings and payment dates; reconcile against dealer statements.
Review quarterly: DV01 drift, counterparty credit, unwind vs roll decision.

Key takeaways

Interest rate swaps exchange fixed and floating coupons on a notional without principal exchange — the standard tool for synthetic fixed/floating transformation.
Swap curves quote par fixed rates by tenor; DV01 sizes how much MTM moves per 1 bp rate shift.
Post-LIBOR USD swaps use compounded SOFR with OIS discounting; Term SOFR and spread adjustments matter for legacy books.
Harbor Capital converted $200M of 4.85% fixed notes to SOFR + 13 bp via pay-fixed swap while keeping the original bond indenture.
CSA collateral calls and basis mismatch between loan index and swap index are the operational risks that break naive hedges.