Reading interest rate swaps: IRS, OIS and swap spreads

It is the largest market in the world, and almost no one talks about it. Beneath every fixed-rate mortgage, every corporate loan, every pension promise, there is an interest rate swap that was used to turn one risk into another. Hundreds of trillions of dollars of notional circulate this way, invisible, until the day they break and take the sovereign bond market down with them, as in the United Kingdom in 2022. This guide takes apart the mechanics of these contracts, from the simplest exchange to the signals they send.

An interest rate swap, in one transaction

An interest rate swap is an agreement in which two parties exchange interest flows calculated on the same reference amount, the notional. One pays a fixed rate, set at the outset; the other pays a floating rate, recalculated each period on a market rate such as SOFR. The counter-intuitive point is that the notional principal is never exchanged: only the interest flows circulate, and most often only the net difference between the two legs is settled.

What is it for? To transform an exposure. A company borrowing at a floating rate, fearing a rise, pays fixed and receives floating: it thereby locks in its funding cost. An investor expecting a fall does the reverse. The swap does not make interest-rate risk disappear, it transfers it to whoever is willing to carry it. Multiplied across the whole economy, this redistribution makes swaps the most widespread tool for managing rate risk, and the largest derivatives market on the planet.

The swap rate and its curve

How is the fixed rate of a swap set? At a level such that, at the outset, the contract is worth nothing to either party: this is the swap rate, the one that equalizes the expected value of the fixed and floating flows. By construction, it therefore embeds the path the market expects for the floating rate over the whole life of the contract. A ten-year swap rate sums up in a single number what the market thinks about short rates for the coming decade.

Linking the swap rates of all maturities gives the swap curve, a benchmark parallel to that of government bonds. The two curves track each other closely, but the gap between them, discussed below, carries valuable information. For banks and corporates, the swap curve is often the most direct pricing reference, because it reflects the real cost of hedging rather than the yield of a particular security.

OIS: the risk-free rate and bets on the central bank

One family of swaps deserves special attention, the OIS, for Overnight Index Swap. Its floating leg is not a three-month rate but the overnight rate compounded over the period, SOFR in the United States. Because that overnight rate tracks the central bank’s policy rate very closely, an OIS quote directly reveals what the market expects of monetary policy. Reading the OIS curve means reading the bets on coming rate hikes and cuts, central-bank meeting by meeting.

The OIS plays a second role, more technical but fundamental: it serves as the “risk-free” rate for discounting the future flows of derivatives. Since the 2008 crisis, which showed that banks were not risk-free among themselves, the market has abandoned LIBOR in favour of OIS discounting. It is invisible plumbing, but it underpins the valuation of trillions of contracts.

From LIBOR to SOFR: the great shift

For decades, the floating leg of swaps was indexed to LIBOR, an interbank rate calculated from banks’ submissions. The scandal over its manipulation, revealed after 2008, sealed its fate. For the dollar, LIBOR stopped being published at the end of June 2023, replaced by SOFR, a rate backed by actual repo transactions on Treasuries, hence far harder to rig. We detail how it is built in our repo and SOFR guide.

The shift is not just a change of name. LIBOR embedded a bank-risk premium and existed for several maturities; SOFR is an overnight, secured rate with no credit premium. The whole edifice of swaps had to be rebuilt on this new foundation, and once-common instruments, such as forward rate agreements, have virtually disappeared in the post-LIBOR world. It is one of the largest market overhauls ever undertaken, and it happened almost without a hitch.

The swap spread: swap versus Treasury

Back to the gap between the swap curve and the government-bond curve. This swap spread is the difference between the swap rate and the Treasury yield of the same maturity. Long positive, it reflected a logical premium: a swap with a bank is deemed slightly riskier than a government bond. Since 2015, however, the long-maturity swap spread has turned negative, an apparent anomaly where the swap rate is below the government yield.

This inversion is not a market error, it is a signal. Holding a physical Treasury consumes balance sheet and regulatory capital for a bank, whereas a swap, off balance sheet, consumes almost none. When the balance-sheet constraint tightens, investors prefer the synthetic exposure of the swap to the physical security, pushing the swap rate below the government yield. The swap spread has thus become a barometer of balance-sheet and bank-regulation pressures, as much as of credit risk. A sharp tightening or widening can also betray the unwind of a leveraged arbitrage, like the roughly $60 billion of positions unwound in April 2025, an episode we tied to the basis trade in our dedicated article.

Clearing and margin: the safeguard that can bite

After 2008, regulators sought to reduce the risk that a counterparty default on a swap would spread. The answer was central clearing: most standardized swaps now pass through a clearing house, a central counterparty that steps between the two parties and guarantees the flows. In exchange, it demands margin: an initial margin posted as collateral, and a variation margin marked to market every day.

This setup makes the system safer in normal times, but it introduces a fragility channel. When rates move violently, variation-margin calls explode, and participants must find cash immediately to meet them. If they do not have it on hand, they sell assets, often the most liquid ones, which can amplify the initial shock. Margin protects against counterparty risk, but it transmits liquidity risk. This is exactly the mechanism that nearly took down the UK debt market.

When swaps break: the UK LDI spiral

In 2022, British pension funds heavily practised liability-driven investment, or LDI: to hedge their very long-term obligations, they held gilts and leveraged interest rate swaps. As long as rates rose slowly, all was well. On 23 September 2022, an unfunded budget sent gilt yields soaring at an unprecedented pace.

The loop was under way: rising yields, margin calls on leveraged positions, gilt sales to find cash, further yield rises. Within days, a pension-hedging problem threatened the country’s financial stability. The Bank of England had to intervene in emergency on 28 September 2022, buying gilts to break the spiral. This episode remains the textbook case of the risk that leveraged swaps pose to sovereign debt, a risk the UK regulator is still trying to defuse, as we described in our article on deleveraging the gilt market.

Reading swaps in practice

Interest rate swaps offer several layers of reading. The swap curve gives, better than any other instrument, the price at which the market exchanges rate risk at each maturity. The OIS curve, more precisely, reads as a permanent poll on the central bank’s coming decisions. The swap spread says less about credit risk than about the state of bank balance-sheet constraints, and a sharp move can signal an arbitrage unwind. Finally, the margin mechanism is the channel through which a rate shock becomes a liquidity shock: watching who is leveraged on swaps, and with what collateral cushion, means watching the next possible accident.

One last caution guards against a misleading figure. The size of the swap market is measured in notional, and that notional runs into the hundreds of trillions of dollars, enough to alarm. But the notional is never exchanged: the real risk bears only on the net flows and the market value of the contracts, a tiny fraction of that amount. As often in finance, the biggest number is not the most dangerous; the danger lies in leverage and margin, not in the notional on display.

Sources and further reading

• Bank for International Settlements, OTC derivatives statistics: the size of the interest-rate swap market in notional.
• Bank for International Settlements, “Beyond LIBOR: a primer on the new benchmark rates”: the transition to risk-free rates.
• Federal Reserve Bank of New York, Secured Overnight Financing Rate (SOFR): the reference rate for dollar swaps.
• Bank of England, gilt market operation, 28 September 2022: the response to the LDI crisis.
• l0g, Gilts: deleveraging before the next accident and Basis trade: at its peak per the Fed, moribund per the market.
• Related guides: Reading the repo market and SOFR and Reading the Treasury market.