Who actually uses interest rate swaps, and why?

Swaps aren't abstract. They exist because real balance sheets have the wrong shape, and rebuilding the balance sheet is expensive while swapping the cashflows is cheap.

Use case 1 — the borrower who wants certainty

A company has a $10,000,000 floating-rate loan at reference rate + 1.50%. If the reference rate is 3%, it pays 4.50%. If it rises to 6%, it pays 7.50%. The company can budget for a lot of things, but not that.

It enters a swap as the fixed payer at 4.00%. Now add up all three flows:

• Pays the bank: reference + 1.50%
• Pays on the swap: 4.00% fixed
• Receives on the swap: reference

The reference rate appears once with a minus and once with a plus. It cancels. The company's all-in cost is 4.00% + 1.50% = 5.50% fixed, whatever rates do. The loan itself never changed — the lender may not even know. Only the cashflow shape changed.

Note what this is not: it is not free money, and it is not a bet that rates will rise. If rates fall to 1%, the company still pays 5.50% while an unhedged borrower pays 2.50%. Certainty was purchased, and the price of certainty is that you don't get the good outcome either.

Use case 2 — matching assets to liabilities

A pension fund owes payments decades into the future — long, fixed-like obligations. Its assets may be shorter or floating. An insurer can hold the mirror-image mismatch. Both can move toward a match by receiving fixed on a swap rather than by selling and rebuying billions of dollars of bonds. The swap is the cheap adjustment layer sitting on top of a portfolio too large and too illiquid to reshuffle.

Banks do the same thing constantly: deposits reprice fast, mortgages don't, and swaps close the gap.

Whether a swap's mark is settled in cash daily is a term of the contract rather than a property of swaps. A corporate hedging a loan is usually exempt from mandatory clearing and margin as an end user and often posts nothing: its losing swap is a balance-sheet liability the bank carries and charges for, with no cash call. A pension fund receiving fixed against its liabilities usually does post. In late September 2022 UK pension schemes faced variation margin calls as gilt yields rose after the 23 September fiscal statement, sold gilts for cash, pushed yields higher, and on 28 September the Bank of England began buying long gilts to stop the spiral. The hedge was right and the cash was not there.

Use case 3 — taking a view

Some users have no underlying exposure at all and enter a swap because they expect rates to move. This is speculation, and it is legal, disclosed and a normal part of a functioning market — the same market that lets the corporate borrower hedge exists because someone is willing to take the other side. Recognising which of the three uses a headline is describing is a genuine reading skill.

The catch worth knowing — basis risk

A hedge is rarely perfect. If the loan references one rate and the swap references another, or the reset dates differ by a month, a residual gap survives. That gap is called basis risk, and it is the reason "fully hedged" in a press release deserves a second read.

Try it now

1. Take the 5.50% all-in cost above. The floating index over the last three years is below as annual fixings: SOFR, read on the first business day of each year. Treat each as that year's rate and compute what the unhedged borrower would have paid each year at reference + 1.50% on the $10,000,000 loan.

2. Compare the three-year totals. In which years did the hedge cost money, and in which did it save money?
3. Write one sentence describing what the company actually bought — the word "certainty" should appear and the word "profit" should not.