Interest Rate Swaps (IRS)

One side pays fixed, the other pays floating

interest rate swap: on the same notional principal, one side pays fixed interest and the other pays floating interest. The principal itself is never exchanged.

Each period only the net is paid

The two interest payments don't each have to be paid in full: they offset and only one side pays the net amount. When floating is above fixed, the fixed payer receives money; otherwise the fixed receiver does.

The floating side follows the benchmark rate

Floating interest isn't set arbitrarily: it resets at the start of each period to the benchmark rate of the time, most often SOFR for dollar swaps. The fixed side stays the same from signing to maturity, so the two sides are really betting on where rates go.

Key takeaways

• Interest rate swap: exchange fixed interest for floating interest on a notional principal; the principal itself isn't exchanged.
• The floating leg resets each period to the current benchmark rate (such as SOFR); the fixed leg stays the same throughout.
• The side paying fixed and receiving floating (payer) benefits when rates rise; the side receiving fixed (receiver) benefits when rates fall.
• Each period, only the net amount is paid.

Try it yourself

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

1. Click “Example”: period 1 floating 5%, fixed 4%, notional principal $10 million. Does A receive or pay? How much net?
2. Press ▶ to play 5 periods and watch the middle: how do the two arrows merge into one net payment?
3. Set “Shift all floating rates” to −2% and play again: what color does A's cumulative net turn?
4. Did the $10 million notional principal ever leave A or B during the whole process?

Quiz and explanations

1. On $10 million notional, you pay fixed 4% and receive floating. This period's floating rate is 5% (paid annually). What's the net payment?

Answer: Receive $100,000.(5% − 4%) × $10 million = $100,000.

2. Is the principal exchanged in an interest rate swap?

Answer: No, only interest is exchanged.The principal is just a "notional" base for the calculation.

3. On $20 million notional, A pays fixed 3.5% and receives floating. This period the floating rate resets to 3% (paid annually). This period A…

Answer: Pays $100,000.A pays $700,000 and receives $600,000, so after netting it pays (3.5% − 3%) × $20 million = $100,000.

Terms in this lesson

• fixed leg (Fixed Leg): The cash flows in a swap that pay interest at a fixed rate.
• floating leg (Floating Leg): The cash flows in a swap that pay interest at a floating reference rate such as SOFR.
• interest rate swap (Interest Rate Swap): Two parties swap fixed interest for floating interest on the same notional, paying only the net difference.
• notional principal (Notional): The amount used to calculate swap interest; it usually never changes hands.
• payer swap (Payer): The side of a swap that pays fixed and receives floating, which gains when rates rise.
• receiver swap (Receiver): The side of a swap that receives fixed and pays floating, which gains when rates fall.
• SOFR: The Secured Overnight Financing Rate, the most common benchmark for US dollar floating-rate loans and interest rate swaps.