Interest Rate Swaps: How Fixed and Floating Cash Flows Are Exchanged

The instrument in one paragraph

An interest rate swap is an agreement to exchange periodic payments computed on a notional amount, where one payment stream is tied to a fixed rate and the other to a floating rate. The BIS glossary defines interest rate swaps as “contracts to exchange periodic payments related to interest rates on a single currency (fixed for floating or floating for floating based on different indices).”

That definition covers most of the market. The variants change the index, the reset frequency, the currency or the direction, but the structure — one leg fixed, one leg floating, net settlement — is the standard form.

The two legs and the netting

Take a five-year swap on a $10,000,000 notional. Party A agrees to pay 4.00% fixed annually. Party B agrees to pay the floating rate annually. The payments are computed on the same notional:

• A’s fixed payment: $10,000,000 × 4.00% = $400,000
• B’s floating payment: $10,000,000 × the floating rate set for that period

If the floating rate for the year is 4.60%, B owes $460,000 and A owes $400,000. The two obligations are netted and B pays A $60,000. Neither party pays the other $460,000 and $400,000 separately, and neither pays the notional.

That netting is the reason the cash that moves is small relative to the notional. It is also the reason a swap can be described as a series of forward agreements: each period’s net payment is a bet on where the floating rate will set relative to the fixed rate.

Why the notional is not exchanged

The notional is a reference amount. In a plain vanilla swap, no principal is transferred at inception and none is returned at maturity. Each party keeps its own assets and liabilities. What changes is the shape of the interest cash flows on the exposure being hedged.

This matters for reading risk. A $10,000,000 swap does not put $10,000,000 at risk. It puts at risk the replacement cost of the swap — the cost of replacing the remaining cash flows at current market rates — which at inception is zero and afterwards is a small fraction of the notional. The BIS definition of notional amounts outstanding is explicit that the figure is the “gross nominal or notional value of all deals concluded and not yet settled,” not a measure of exposure.

Pricing: the par rate and the forwards

A swap is priced off the curve of expected floating rates. The fixed rate that makes the swap worth zero at inception is called the par swap rate. It is the rate that equates the present value of the fixed leg to the present value of the floating leg.

Two consequences follow.

First, the floating leg’s present value is not a forecast of every future floating payment. At a reset date, a floating-rate leg discounted on the same curve is worth par — the notional. That is why a par swap can be valued as the notional minus the present value of the fixed leg.

Second, the par rate embeds the market’s forward curve. If the market expects the floating rate to rise, the par fixed rate will be above the current floating rate; if it expects the floating rate to fall, the par rate will be below it. The swap does not reveal which expectation is correct. It reveals what the market has priced.

A worked example: two years of net payments

On a $10,000,000 notional with annual payments, A pays 4.00% fixed and receives floating.

Over the two years A’s net position is a $20,000 cost, but the path matters: A was paid in year one and paid in year two. A company hedging a floating-rate loan with this swap would have locked its all-in cost at 4.00% plus the loan spread, and the swap’s net payments would offset the difference between the loan’s floating rate and 4.00%. In year one, when the loan reset at 4.60%, the swap paid $60,000 back; in year two, when it reset at 3.20%, the swap cost $80,000. The total interest cost is stable even though the swap’s cash flow is not.

A worked example: marking the swap to market

Now value the same swap as a five-year contract, priced on a flat curve, with annual payments and a 4.00% fixed rate. At inception, with the curve at 4.00%, the swap is worth zero: the present value of the fixed leg equals the notional.

If the curve moves to 5.00% immediately after inception, the floating leg is still worth the notional (it resets to market), while the fixed leg falls:

• Present value of fixed leg at 5.00% = $400,000 × 4.32948 + $10,000,000 / 1.05^5 = $9,567,052
• Value to the fixed payer = $10,000,000 − $9,567,052 = +$432,948

A 100 basis point rise in rates turned a zero-value swap into a claim worth about 4.33% of the notional for the party paying fixed. The same move in the other direction, to 3.00%, produces a liability of about $457,971.

That 4.33% is a duration figure in disguise. The fixed leg of a five-year par swap has a modified duration near 4.45, and the value change is approximately duration × the rate change × the notional. This is why a swap is described as a duration instrument: it transfers interest rate sensitivity without transferring principal.

What the swap does to risk

A payer swap — pay fixed, receive floating — gains value when rates rise. A receiver swap — receive fixed, pay floating — gains when rates fall. The magnitude is set by the fixed leg’s duration and the notional.

For a hedger, the logic is to match the swap’s sensitivity to the exposure. A company with a $10,000,000 floating-rate loan has interest cost that rises with the floating rate. Paying fixed on a swap of matching size and tenor converts that exposure into a fixed cost, with the swap’s gains and losses offsetting the loan’s rate resets. If the sizes or tenors do not match, the hedge is partial, and the residual is a real position rather than a rounding error.

For a speculator, the swap is a way to take duration exposure without buying the underlying bond. The capital required is margin rather than the full notional, which increases the return on capital and the loss per unit of adverse move in the same proportion.

Clearing and counterparty risk

The CFTC’s clearing requirement page states that final rules require certain classes of credit default swaps and interest rate swaps to be cleared by derivatives clearing organisations registered with the Commission. Clearing sits between the two original counterparties: each faces the clearing house rather than the other.

That changes the form of counterparty risk, not its existence. The clearing house is backed by initial margin, variation margin and a default fund, and it can call for more collateral when markets move. A participant that cannot meet a margin call faces liquidation of its position even if its view would eventually have been proved right. Clearing also makes positions more standardised and more reportable, which is why the same rules that require clearing also push transactions toward regulated execution venues.

A swap that is not cleared carries bilateral credit exposure instead. The surviving party in a default must replace the contract at the current market rate, which is the replacement cost described earlier.

Where the mechanics bite

Reset conventions. The floating rate for a period is usually set at the start of the period and paid at the end. Which day counts, which index is used, and how the rate is compounded all change the cash flows. Two swaps with the same fixed rate and tenor can differ in value because of conventions alone.

Discounting. Post-crisis practice discounts collateralised cash flows on an overnight rate rather than a term rate. The choice of discount curve changes the present value of both legs and therefore the par rate.

Collateral and funding. A swap that is in the money requires the winner to post variation margin to the clearing house. The position can be economically right and still create a liquidity demand at the wrong moment.

Basis. A floating leg that references one index does not perfectly hedge a liability that references another. The residual is basis risk, and a basis swap is the instrument that isolates it.

Termination. Closing a swap before maturity means paying or receiving its replacement cost. There is no free exit, and in a stressed market the cost of exiting can exceed the mark-to-market value computed from mid rates.

The repo versus policy rates guide covers how the overnight rate that anchors floating legs is set in practice, and the duration guide covers the sensitivity measure that makes the swap a hedging instrument in the first place. For the primary market that produces the fixed-rate benchmark, the T-bill auction guide describes the issuance side.

How these sources were checked

The definition of interest rate swaps, the definition of notional amounts outstanding, and the fixed-for-floating and floating-for-floating structures come from the BIS OTC derivatives statistics glossary, retrieved 2026-10-24. The clearing requirement for certain classes of interest rate swaps comes from the CFTC’s Clearing Requirement page, retrieved 2026-10-24.

The cash-flow and valuation tables are arithmetic on the stated notional, fixed rate and assumed floating rates, using annual payments and a flat discount curve for transparency. They are illustrative and omit day-count conventions, collateral discounting and credit spreads, all of which change a real swap’s value. No market swap rate is quoted because none was verified against a primary source for this piece.