Explain an interest rate swap.
A core Corporate Treasury interview question — asked in analyst and associate interviews across IB, PE, and the Big 4.
THE SHORT ANSWER
An interest-rate swap is an agreement between two parties to exchange interest payments on a notional principal: typically one pays a fixed rate and receives floating (a reference rate like EURIBOR/SOFR plus spread), the other does the reverse. The principal is notional — never exchanged — and settlement is net (only the difference between the two legs changes hands each period). Corporates mainly use it to convert floating-rate debt to fixed (a pay-fixed swap, locking in interest cost and removing rate-rise risk) or, less often, fixed to floating. Economically it's a strip of forward rate agreements. Key points: at inception the swap is priced at zero value (the fixed rate equals the par swap rate), it then carries a mark-to-market as rates move (creating collateral/CSA calls and break costs on early termination), and under IFRS 9 a pay-fixed swap on floating debt is usually designated as a cash-flow hedge. It hedges interest cost but introduces MTM/collateral and break-cost considerations.
WHAT INTERVIEWERS LISTEN FOR
- ✓Exchange fixed vs floating interest on a notional; principal not exchanged; net settled
- ✓Corporates: convert floating debt to fixed (pay-fixed) to lock cost
- ✓Zero value at inception; carries MTM → collateral/CSA and break costs
- ✓Typically a cash-flow hedge under IFRS 9
COMMON MISTAKES
- ✗Thinking principal is exchanged
- ✗Ignoring MTM/collateral and break-cost implications
- ✗Not linking to hedge accounting
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RELATED QUESTIONS
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