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What is an Interest Rate Swap?
An interest rate swap is an over-the-counter (OTC) derivative in which two parties exchange interest rate cash flows. Typically, one party (the borrower) pays a fixed rate and the other (the bank providing the swap) pays a floating rate. The floating rate is usually SONIA for sterling loans and Euribor in the Eurozone. For borrowers with floating-rate loans, a pay-fixed interest rate swap converts variable interest expense into a predictable fixed rate, providing certainty of cash flow and protection against rising rates throughout the term of the loan.
The most common structure — the “vanilla swap” — involves the borrower paying a fixed rate to a hedging bank and receiving SONIA or Euribor in return. The floating receipts under the swap offset the floating rate paid on the underlying loan, leaving the borrower with a net fixed interest cost. Interest rate swaps are widely used by commercial real estate (CRE) borrowers, leveraged buyout vehicles, infrastructure funds, and operating companies with term loan facilities.
Along with Interest Rate Caps and Interest Rate Collars, interest rate swaps are one of three principal OTC hedging instruments available to floating-rate borrowers.
How does an Interest Rate Swap work?
A floating-rate commercial loan carries two interest components: the loan margin (fixed, agreed at loan origination) and a variable reference rate (SONIA for sterling loans; Euribor for euro loans), which usually resets quarterly. The variable rate creates uncertainty in the borrower’s total interest cost and cash flow.
With a pay-fixed interest rate swap in place, the borrower continues to pay the full loan interest (margin plus floating rate) to the lending bank as normal. Separately, under the swap with the hedging bank, a net settlement is calculated each quarter:
• Borrower pays: the agreed fixed swap rate on the notional amount.
• Borrower receives: the prevailing SONIA or Euribor rate on the same notional amount.
• Net result: the floating receipts on the Swap cancel out the floating component of the loan, leaving the borrower with a net fixed interest cost of: swap rate + loan margin.
In practice, the net settlement on the swap is a single cash payment each interest period-either from the borrower to the hedging bank (if the fixed rate exceeds the floating rate) or from the hedging bank to the borrower (if floating exceeds fixed). The borrower’s net fixed rate is always the swap rate plus the loan margin (if there is no interest rate floor in the loan agreement)
What are swap rates?
A swap rate is the fixed interest rate paid by the borrower in an interest rate swap, set at a level that makes the present value of the fixed cash flows equal to the present value of the expected floating cash flows over the swap’s term. It is derived from the forward curve — the market’s current forecast of where SONIA or Euribor will set at each future interest period.
The swap rate is therefore not a subjective number: at any given moment, it is determined by the shape of the forward curve. Different hedging banks quoting the same swap structure at the same time should quote identical (or near-identical) mid-market swap rates, because they are all reading from the same forward curve.
How swap rates are priced: A worked example
The table below illustrates the swap rate calculation for a £10 million, three-year floating-rate loan, using an illustrative SONIA forward curve. Each quarterly period shows the forecast SONIA rate, the resulting floating interest cost, and the equivalent fixed interest payment at the derived swap rate of 4.35%:
How the swap rate is solved: working from the forward curve, the total expected floating interest expense over three years is £1,216,948. The swap rate is the single fixed rate that, applied quarterly over the same three-year term and the same notional, produces the same total present value-in this case 4.35%. This is a standard present value calculation performed by every hedging bank’s pricing desk.
The mid-market swap rate is a theoretical fair-value price. In practice, the rate quoted to the borrower will be higher than mid-market. Hedging banks add a mark-up (spread) to cover credit risk, operational costs, regulatory capital charges, and profit margin. This mark-up is largely discretionary and varies significantly between banks, which is why independent benchmarking matters.
Vuca Treasury Insight- The swap spread is negotiable
Many borrowers focus their negotiation entirely on the loan margin and treat the swap rate as non-negotiable. It is not. The mid-market rate is observable, and the mark-up above it is a commercial decision by the hedging bank. Vuca Treasury benchmarks live swap quotes from multiple hedging banks on your behalf, ensuring the mark-up charged is fair and competitive. On larger or longer-dated transactions, this can represent a material saving.
What are the risks/considerations?
Like any contractual commitment, Interest Rate Swaps carry risks. Vuca Treasury recommends that the following factors are taken into consideration when contemplating an interest rate swap for SONIA or Euribor term loans:
Early Terminations and Mark-to-Market (MtM) Exposures
A material risk of an interest rate swap is the potential cost of early termination. Unlike an interest rate cap, where early termination is typically free for upfront-premium structures, breaking a swap before maturity requires settling its current mark-to-market (MtM) value. If market rates have fallen since the swap was executed, the borrower will be paying above-market fixed rates, and the MTM value will be a liability, potentially a very large one.
MTM liabilities can be particularly problematic in loan refinancing scenarios — if the borrower refinances with a different lender, the swap with the original hedging bank must typically be terminated or novated, and any MtM liability becomes immediately payable. Borrowers should model break cost exposure at the outset of any transaction and consider it when comparing a swap against a cap.
The table below illustrates indicative MTM liabilities for a £10 million, five-year swap executed at 4.35%, at the two-year mark under different rate scenarios:
Hedge Accounting and P&L Volatility
The MTM value of an interest rate swap fluctuates continuously with market rates. How this is reflected in the borrower’s accounts depends on whether hedge accounting is applied:
• Cash flow hedge accounting: MTM movements are recorded in Other Comprehensive Income (OCI) rather than the income statement, reducing P&L volatility. This is the most common treatment for swaps used to hedge floating-rate loan exposure.
• Fair value hedge accounting: both the swap’s MTM and the hedged item’s fair value change flow through the income statement. Less common for vanilla pay-fixed swaps.
• No hedge accounting (mark-to-market through P&L): the full MTM movement is recognised in the income statement each period, creating significant reported earnings volatility even though the economic hedge is effective.
Borrowers should assess the hedge accounting treatment before executing a swap, particularly where KPIs or loan covenants reference EBITDA, net income, or balance sheet ratios. Vuca Treasury works alongside the borrower’s auditors and finance team to ensure the correct accounting designation is in place at execution.
Some Banks include a hedge as a condition of loan sanction. It’s important to remember that the Swap rate can move significantly while the loan is being negotiated and before financial close. This may actually impact some key terms, like your debt capacity, especially when leverage is high. Borrowers should also negotiate the Swap spread before signing a term sheet. Many borrowers are focused on negotiating the loan itself and, to their cost, neglect this aspect when arranging a loan. Again, using an advisor like Vuca Treasury can guide you through this process.
Documentation for SONIA & Euribor Swaps
The industry standard documentation for Swaps is an ISDA Master Agreement and Schedule. The Schedule aligns terms in the Swap with the loan and is typically heavily negotiated. It can also be expensive and time consuming. Key provisions include language around termination events. Other important documents are the Swap Confirmation and a Credit Support Annex (CSA) which may, or may not, be required.
Important: the ISDA Schedule negotiation can extend significantly if the borrower’s corporate structure is complex, if the loan documentation contains unusual termination events, or if lender consent is required before the swap can be executed. Borrowers should not assume that swap documentation can be completed quickly. Vuca Treasury manages the full documentation process on behalf of our clients, drawing on extensive experience of both standard market terms and lender-specific requirements.
Interest Rate Floor mismatch
Many loan agreements contain an interest rate floor — a minimum rate applied to the floating reference rate (SONIA or Euribor), regardless of where the market rate sets. This was previously an issue when euribor was negative as most loan documents had a floor at 0.0%. This creates a structural mismatch with a pay-fixed swap when the market rate falls below the floor.
The mismatch arises because:
• The loan: the borrower pays the lender based on the floor rate (e.g. 0.00%), not the market rate (e.g. -0.50%)
• The swap: the swap settlement is based on the difference between the swap rate and the market rate (not the floor)
• The result: the swap no longer provides a perfect hedge. The borrower’s effective rate exceeds the intended fixed rate by the amount of the floor-to-market gap
Worked example — floor mismatch (€10m loan, 0.00% floor, 2.50% swap rate):
Current relevance: Most lenders have floors at 0.0% in their loan agreements, which doesn’t pose an immediate risk. However, we have seen lenders in the UK and European markets with floors in their loan agreements as high as 3.50%.
Solutions: The mismatch can be addressed by adding a matching floor to the swap (so that the borrower receives the floor rate, not the market rate, when Euribor is below the floor). Alternatively, interest rate caps avoid the mismatch entirely, as caps are not affected by this structural problem. Fixed rate loans avoid this issue.
Credit Risk
By entering a swap with a hedging bank, the borrower and the hedging bank take on credit exposure to each other for the full term of the hedge. Because swap payments can be positive or negative, the credit exposure is two-way: either party can be in-the-money at any point.
Where the lending bank and hedging bank are the same entity, the hedging bank typically secures its exposure against the underlying asset. Where they are different entities, a separate collateral arrangement — often a Credit Support Annex (CSA) — is required. In practice, finding a third-party hedging bank willing to enter an unsecured swap can be difficult and expensive for borrowers with complex capital structures. In these cases, an Interest Rate Cap (which creates one-way credit exposure only) may be the more practical instrument
- Interest rate swaps are regulated financial instruments under MiFID II. Most hedging banks will only provide swap contracts to clients who qualify as professional clients under MiFID II — a classification based on the client’s financial experience, knowledge, and the size of their financial instrument portfolio. Clients who do not meet the professional client threshold are classified as retail clients and may find that some banks will not provide them with swap products at all.
To be automatically classified as a professional client, a company or SPV would need to satisfy two of these three conditions:
• Have a Balance Sheet in excess of €20m
• Have Turnover in excess of €40m
• Have Own Funds in excess of €2m
To elect up to be treated as a professional client, the main eligibility criteria include:
• The client has carried out transactions of significant size in the relevant market at an average frequency of ten per quarter over the previous four quarters.
• The client’s financial instrument portfolio (including cash deposits) exceeds €500,000.
• The client works or has worked in the financial sector for at least one year in a professional position requiring knowledge of derivative transactions.
A client needs to satisfy at least two of the three criteria above to be considered for professional client classification. In practice, many CRE borrowers — particularly first-time or infrequent borrowers — may not meet these criteria, and some banks will decline to offer them a swap.
How VUCA can help?
Vuca Treasury is an independent, unbiased treasury consultancy specialising in interest rate risk management for borrowers in the real estate, corporate, and private equity sectors. Our advisors have multi-decade experience in the financial and capital markets divisions of major global banks — giving us direct insight into how hedging banks structure, price, and mark up derivative products.
Unlike a bank or broker with products to sell, our recommendations are wholly independent. We act exclusively in the interests of the borrower. Our full-lifecycle service covers:
1. Instrument selection and structuring — assessing whether a swap, cap, or collar is the most appropriate instrument for your specific transaction, rate outlook, and covenant requirements.
2. Hedging bank selection and onboarding — identifying counterparties offering the optimal combination of competitive pricing, credit quality, and documentation efficiency.
3. Swap rate benchmarking and execution — obtaining live quotes from multiple hedging banks and benchmarking the mark-up to ensure best execution.
4. ISDA documentation management — negotiating the ISDA Master Agreement, Schedule, and Confirmation on your behalf, with reference to your loan documentation.
5. Post-trade support — providing periodic MTM valuations, monitoring counterparty credit quality, and managing any required amendments, novations, or break cost analyses over the life of the swap.
To request a free swap benchmarking analysis, comparing live quotes from multiple hedging banks to ensure you receive a fair and competitive swap rate, please contact us at info@vucatreasury.com.
Our client, McGarrell Reilly, who we worked with on their Charlemont Square project in Dublin 2, said “We are really pleased to have placed our interest rate caps in a timely and efficient manner and I would like to thank our advisor, Vuca Treasury, for delivering such a great result for the business”.
