Swaps Path

A **fixed-rate** loan pays the same coupon for the life of the deal. A **floating-rate** loan resets its coupon each period to a market benchmark, in Australia typically **3-month BBSW** plus a credit margin. Fixed exposure shifts price risk to the borrower's balance sheet (the loan's mark-to-market moves when yields move) while floating exposure shifts cash-flow risk (payments rise and fall with the benchmark). An **interest rate swap** lets a borrower convert one into the other without refinancing the underlying loan.

**LIBOR** (London Interbank Offered Rate) was the dominant global floating benchmark for decades. **USD LIBOR ceased on 30 June 2023** and was replaced by **SOFR**, an overnight collateralised rate. In Australia, **BBSW** (Bank Bill Swap Rate) remains the primary floating reference and is administered by the **ASX** since 2017. BBSW is now calculated daily from actual transactions in bank-accepted bills and negotiable certificates of deposit, with tenors from one to six months.

A **vanilla interest rate swap** is an OTC contract in which two parties exchange interest payments on a **notional principal** for a set of dates over a fixed term. One leg pays a **fixed rate** $r_{\text{fix}}$. The other pays a **floating rate**, typically **3-month BBSW** in Australia. Only the **net cash flow** is exchanged each period, and the notional itself never changes hands. Interest rate swaps are the largest OTC derivative class, with BIS data showing **interest rate derivatives at roughly 79% of US$846 trillion** in notional outstanding at end-June 2025.

The textbook rationale for an interest rate swap is **comparative advantage**. One borrower may face better terms in fixed-rate funding while another faces relatively better terms in floating. Each borrows where its advantage is largest and the two parties swap payment streams. The **total gain** equals the **quality spread differential** (QSD), the absolute difference between the two parties' fixed-rate gap and floating-rate gap. Hull (2022) §7.4 notes the argument has been criticised because true comparative advantage in efficient capital markets should not survive long-term arbitrage.

A **direct swap** is a bilateral OTC contract between two end-users. An **intermediated swap** runs through a **swap dealer** (typically a major bank) that enters back-to-back swaps with each side. The intermediary takes a small **bid-offer spread** in exchange for matching counterparties, bearing **credit risk**, and providing standardised **ISDA documentation**. Post-Dodd–Frank, many standard swaps are now also cleared through a **central counterparty** (CCP), adding a third structural layer.

An intermediated swap has two **legs**, the **fixed leg** and the **floating leg**. The dealer bank quotes different rates on each side. On the fixed leg the bank receives a slightly higher fixed rate from one counterparty than it pays the other. On the floating leg both rates are typically BBSW flat, with the bank's spread embedded in the fixed-leg differential. The **bank fee** equals the total quality spread differential (QSD) minus the savings passed to the two end-users. Vanilla bid-offer spreads for liquid Australian dollar swaps are typically only a few basis points per annum.