How to Account for Interest Rate Swaps

by Patrick Gleeson, Ph. D.,; Updated June 27, 2018

In late 2007, as the U.S. subprime mortgage market began rapidly going south, leading to the second-worst economic collapse in U.S. history, economists and financial writers began writing about the role of "credit default swaps" in the collapse. As it worsened, media accounts increasingly abbreviated "credit default swaps" to "swaps." How swaps were implicated was seldom explained, but readers were left with the general impression that swaps were extremely risky – just overall bad.

Ironically, while many economic concepts are complicated, swaps are not. Interest rate swaps are particularly straightforward, being no more or less than what the phrase states: the exchange or "swap" of one interest rate for anothe_r. In a further irony, although the association of credit default swaps with the Great Recession have given swaps, in general, a bad reputation, _one of the underlying purposes of interest rate swaps is to reduce or control risk.

What's an Interest Rate Swap?

An interest rate swap retains the principal amount of a loan but most often swaps the interest rate type with another loan in the same amount with a different interest rate type. The principal amount remains the same, but a fixed rate loan then becomes a variable rate loan or a variable rate loan becomes a fixed rate loan.

Both in practice and under generally accepted U.S. accounting principles (GAAP), interest rate swaps are derivatives. Instead of the two parties actually exchanging the two loans, they make an agreement that exchanges the two obligations. One party becomes responsible for the stream of interest payments on the fixed rate loan; the other assumes responsibility for the interest payments on the variable rate loan. The terms of a specific interest rate swap are customized with the agreement of the two parties and are traded Over the Counter (OTC), meaning that the swap takes place without an intermediary trading exchange. Most often the two parties to an interest rate swap are a bank and private party or corporation.

Reasons for an Interest Rate Swap

There are many reasons for an interest rate swap including portfolio management, risk management, corporate interest rate hedging, rate locks on bonds and speculation. Some possible scenarios are:

  • Your company is unable to secure a fixed rate business loan. Instead, you take out a $1,000,000 loan with a variable 4.25 percent annual interest rate. You estimate your projected future cash flows will give you enough liquidity to pay the loan interest even if the rate rises to 6 percent. If it should rise further, however, you could have a cash flow problem. To protect yourself from this, you swap your variable rate loan for a fixed rate loan. 
  • Your bank manages risk by lending both fixed-rate and variable rate loans. Bank actuaries determine that the most variable mix of risk and reward occurs when the total loan amounts for each type are about equal, but recent lending activity has resulted in a surplus of fixed rate loans. To correct the imbalance, the bank enters into interest rate swaps with corporations that prefer a fixed rate loan.


  • Familiarize yourself with how the fair value of a liability can change when interest rates change. The higher the interest rates, the lower the fair value of a liability, and vice versa.
  • Also, learn what it means for a business when the fair value of its liability changes. The lower the fair value of a liability, the more a business gains by owing less, and vice versa.

About the Author


bibliography-icon icon for annotation tool Cite this Article