How do you work out the variable interest rate paid in an interest rate swap?

How do you work out the variable interest rate paid in an interest rate swap?

• A. Fixed rate determined at inception
• B. LIBOR only, reset annually
• C. Prime rate plus spread, reset monthly
• D. Based on a market reference such as SOFR plus a small spread and reset quarterly

Answer: (D)

In a vanilla interest rate swap, the floating leg isn’t fixed. Its rate is set by a market reference rate observed at each reset, plus a fixed spread that compensates for credit and terms differences. The rate observed at the reset date is applied for the upcoming payment period, using the agreed day-count convention. Using a current market reference like SOFR (or another reference rate) plus a small spread, with resets every quarter, captures how market rates move and when payments are due. That’s why the option describing a market reference such as SOFR plus a small spread and resetting quarterly is the best fit. The other options imply a fixed rate on the floating side, or use a less appropriate benchmark or reset frequency for standard swaps.

In a vanilla interest rate swap, the floating leg isn’t fixed. Its rate is set by a market reference rate observed at each reset, plus a fixed spread that compensates for credit and terms differences. The rate observed at the reset date is applied for the upcoming payment period, using the agreed day-count convention. Using a current market reference like SOFR (or another reference rate) plus a small spread, with resets every quarter, captures how market rates move and when payments are due.

That’s why the option describing a market reference such as SOFR plus a small spread and resetting quarterly is the best fit. The other options imply a fixed rate on the floating side, or use a less appropriate benchmark or reset frequency for standard swaps.