How do fixed-for-floating interest rate swaps work and who benefits from each leg?

Question

AcadiFi · Accepted Answer

A plain-vanilla interest rate swap exchanges a fixed coupon for a floating coupon (typically SOFR + spread) on a notional principal that is never exchanged. Consider Nordhelm Industrial Supply, which borrowed $200 million in floating-rate notes at SOFR+90bp. Management fears rising rates, so they enter a 5-year swap with Tillmark Bank as fixed payer at 4.10% versus receiving SOFR. Net result: Nordhelm pays 4.10% + 90bp = 5.00% fixed synthetically. Tillmark, which holds fixed-rate mortgage assets, becomes the floating payer to match its short-term funding costs. Cash flows settle on a net basis quarterly or semi-annually. If SOFR resets to 4.50%, the fixed payer owes 4.10% and receives 4.50%, netting +0.40% × notional × day-count. The swap's value at inception is zero because the fixed rate equals the par swap rate derived from the discount curve. ```mermaid flowchart LR A[Nordhelm
Fixed Payer] -->|4.10% Fixed| B[Tillmark
Floating Payer] B -->|SOFR| A A -->|SOFR+90bp| C[Bondholders] ``` Key risks: counterparty credit, basis risk if the floating index differs from the hedged liability, and mark-to-market volatility as the swap curve shifts. Dealers warehouse swaps and hedge with Treasuries or futures. Join AcadiFi's FRM community to practice swap valuation.

How do fixed-for-floating interest rate swaps work and who benefits from each leg?

Master Part I with our FRM Course

Related Questions

Practice Questions