Interest Rate Swap (IRS)

In a plain-vanilla interest rate swap, one party pays a fixed rate and receives a floating rate on the same notional amount and currency for an agreed term; the notional itself is not exchanged. Floating legs now reference overnight risk-free rates such as SOFR (USD), SONIA (GBP) or €STR (EUR), after USD LIBOR panel publication ended in June 2023. Variants include basis swaps (floating vs floating), overnight index swaps (OIS), amortizing swaps and cross-currency swaps, which also exchange principal.

Funds use swaps to hedge the rate risk of fixed-income portfolios, to express views on the yield curve, or to convert floating-rate borrowing into fixed. Standard USD, EUR and GBP swaps are subject to mandatory central clearing for many counterparties under Dodd-Frank and EMIR, so they are executed bilaterally but cleared through a central counterparty with daily variation margin. Uncleared swaps are documented under an ISDA with a Credit Support Annex.

How funds account for swaps. A swap is carried at fair value. Each day the operations team accrues the fixed and floating legs, processes rate resets for the floating leg, and books net periodic payments on payment dates as realized gains or losses. Valuation discounts projected cash flows on the relevant OIS curve and is typically a Level 2 measurement in the fair value hierarchy. The mark is compared to the clearing house or counterparty valuation as part of daily collateral management.

Pitfalls. The most common problems are missed or late reset fixings, incorrect day-count conventions (ACT/360 vs 30/360) between legs, confusing clean and dirty valuations when accrued interest is booked separately, and disputes on collateral calls because the fund’s curve set differs from the counterparty’s. Early terminations and novations must be captured promptly, or the swap will remain open in the books after it has economically closed.

Example

A fund pays 3.80% fixed and receives compounded SOFR on USD 25M for five years. If compounded SOFR for a quarterly period is 4.10%, the fund receives the net difference of about 0.30% × 25M × (days/360) on that payment date and books it as realized income on the swap.