Hedging a Floating-Rate Loan with a Swap

Floating loan + swap = fixed cost

The loan pays SOFR + 1%; on top of it sits an interest rate swap that pays fixed 4% and receives floating. The SOFR in the loan is offset by the SOFR received from the swap, so the net cost is fixed at 4% + 1% = 5%. That's a hedge.

The price: you miss out when rates fall

The hedge locks the cost at 5%. When rates soar, it saves a lot; when rates fall, you have to pay into the swap and miss out on cheaper borrowing.

Principal and maturity have to line up

The swap's notional principal, maturity and payment dates should match the loan's one to one. With a 5-year loan and a 3-year swap, the last 2 years go back to a floating rate; hedge only half the principal and you only lock in half the cost.

Key takeaways

• Floating-rate loan + pay-fixed / receive-floating swap = a synthetic fixed-rate liability.
• After hedging, net interest cost = swap fixed rate + loan spread, which barely changes with rates.
• The swap's notional, term and payment dates must match the loan, or some risk is left unhedged.
• The cost of hedging: you don't benefit from lower costs when rates fall.

Try it yourself

You can do these exercises in this lesson's interactive simulation:

1. Click “Example: SOFR rises to 7%”: what's the loan interest? How much does the swap bring back? What % is the net cost?
2. Switch to “Unhedged” and look at the same period: what does the net cost become?
3. Play to year 6 (SOFR 1.5%) and compare “Hedged” and “Unhedged”: which is cheaper? That's the cost of hedging.
4. Raise “Shift the whole SOFR path” to +2%: when hedged, does the net cost line move?

Quiz and explanations

1. A company with a floating-rate loan enters a pay-fixed 4% / receive-floating swap. The floating rate rises to 7%. Roughly what's its net interest cost?

Answer: 4% (plus the loan spread).The extra floating interest it pays is recovered through the swap.

2. What's the cost of this hedge?

Answer: It can't benefit when rates fall.The cost is locked at a fixed level.

3. A $10 million loan pays SOFR + 1.5%. The company enters a swap with the same notional and term, paying fixed 3.8% and receiving SOFR. What's its net borrowing cost?

Answer: 5.3%.The SOFR on the loan is offset by the SOFR received on the swap, leaving 3.8% + 1.5% = 5.3%.

Terms in this lesson

• floating leg (Floating Leg): The cash flows in a swap that pay interest at a floating reference rate such as SOFR.
• hedge (Hedge): An opposite trade that offsets the risk of an existing exposure.
• interest rate swap (Interest Rate Swap): Two parties swap fixed interest for floating interest on the same notional, paying only the net difference.
• SOFR: The Secured Overnight Financing Rate, the most common benchmark for US dollar floating-rate loans and interest rate swaps.