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Interest-rate swap
A plain interest-rate swap is an exchange of interest. One side pays a fixed rate and receives a floating rate. The other side does the opposite. A swaption, on the next page, is the right to enter this contract later. The numbers below are a classroom swap.
01
Fixed against floating
The fixed leg is a rate agreed on the trade date and left unchanged, here 4.00% for 10 years. The floating leg is reset from a published overnight rate. SOFR is the Secured Overnight Financing Rate, a broad measure of the cost of overnight borrowing secured by Treasury securities. Each period, SOFR sets the floating interest for that period.
On this swap the calculation amount is $100 million. The picture shows the two directions of interest. It does not show a transfer of the $100 million.
02
The notional stays put
Notional is the principal used only to size the interest. It is not a loan and not an amount that changes hands. Annual fixed interest is 4% of $100 million, which is $4 million. If SOFR for that year sets at 5%, floating interest is $5 million. The fixed payer receives the $1 million difference. The $100 million is not paid at the start and not repaid at the end.
03
Both sides are obligated
A swap is not an option. After it starts, both sides owe the remaining net payments, even in a year when the net is against them. A treasury that might need to lock a borrowing rate in six months, and might not, does not want that obligation today. The next page is the right to enter the same swap later.
Swaptions are that right.