Swaps, SOFR and rates futures

Most of the rate risk that changes hands on a trading floor never touches a bond. It moves through swaps and futures. A company locks in its borrowing cost with a swap. A pension fund adds duration with a swap. A hedge fund expresses a view on the Fed with SOFR futures, and a dealer hedges its Treasury inventory with Treasury futures in seconds. On many desks the swaps book is bigger than the cash bond book, and futures are the first thing a trader reaches for to hedge.

In an interview these show up as "what is a swap and why would a company use one?", "what replaced LIBOR?" and "how do you read a SOFR futures price?". Each has a clean answer with a number in it. This lesson builds those answers. It assumes you know what a bond and a basis point are; if not, start with Treasuries and money markets.

How a swap works

An interest rate swap has two legs.

• The fixed leg. One side pays a set rate, say 3.80 percent a year, for the life of the swap.
• The floating leg. The other side pays a rate that resets each period. In the US that is now SOFR, an overnight rate covered below.

Both legs are calculated on the same notional, say $500 million. The $500 million is never exchanged. It is only the number the interest is calculated on. On each payment date the two amounts are netted and one side pays the difference.

Zero value at the start. The fixed rate, called the swap rate, is set so that the present value of the fixed payments equals the present value of the floating payments the market expects. So neither side pays to enter, unlike an option, where the buyer pays a premium. After day one, the swap gains or loses value as rates move.

Who wins when rates move. If rates rise, the side paying fixed is now paying a rate below the market, so its swap has positive value. That is exactly how a short bond position behaves: it gains when rates rise. So:

• Pay fixed (a payer swap) is like being short a bond.
• Receive fixed (a receiver swap) is like being long a bond.

Each has a DV01, the dollars made or lost per basis point, just like a bond, which is why the duration lesson applies to swaps without change.

Worked example. A company has a $500 million 5-year loan at SOFR + 2.00 percent. Its CFO does not want the interest bill to swing with the Fed, so it enters a 5-year swap: pay fixed 3.80 percent, receive SOFR, on $500 million. For simplicity, say payments are annual.

Either way the company pays 5.80 percent, which is the 3.80 percent swap rate plus its 2.00 percent loan spread. SOFR cancels out: what it pays on the loan, it receives on the swap.

Now say that a year later, swap rates for the remaining four years have risen to 4.30 percent. The company is paying 3.80 percent on a swap the market would now price at 4.30. Its swap is worth roughly the 0.50 percent saving on $500 million for each remaining year, discounted: about $9.0 million, an asset on its books that offsets the higher interest it would otherwise face.