Interest Rate Swaps · Swaps Trading Guide

A borrowing hedge can stabilise one part of interest expense while leaving other costs variable. Match the loan and swap before calling the combined payment fixed.

Offset the common benchmark

Suppose a loan charges a benchmark plus 1.5%. A swap on the same notional and dates receives that benchmark and pays 4%. The common benchmark payments offset in the simplified combined cash flow, leaving 5.5%. The loan and swap remain separate contracts even when their economics largely offset.

Calculate a period

For $5 million and a half year fraction, a 3% benchmark makes the loan payment $112,500. The swap pays $100,000 fixed and receives $75,000 floating, a net $25,000 payment. Total cash is $137,500, equal to 5.5% annualised over that half year. A higher matching benchmark increases the loan payment but improves the swap settlement.

Find what does not cancel

The loan credit spread can reset while the swap does not. Different benchmarks, payment dates or day counts create residual exposure. A loan floor can stop its rate falling while the received swap rate continues lower. Principal repayments can leave a constant notional swap larger than the remaining debt. Model these conditions explicitly.

Plan for refinancing

Repaying a loan does not automatically cancel its swap. A termination may require payment when the swap has negative value. A hedge can also demand collateral before the offsetting loan benefit arrives. Evaluate the combined financing, liquidity and exit terms rather than treating the fixed rate as the only decision variable.

Try it yourself

A perfectly matched loan costs benchmark plus 2%, and its swap receives benchmark while paying 3.8%. What is the combined rate before other costs?

Show the worked answer

The benchmark cancels, leaving 3.8% plus 2% = 5.8%. The conclusion depends on matching terms and excludes fees, floors and other mismatches.

Further reading

Educational material, not a recommendation to transact. Numerical examples are hypothetical and simplify contract terms. Access, documentation, collateral and regulatory requirements depend on the product, jurisdiction and counterparties.

Continue learning