Understanding Interest Rate Swaps

A comprehensive guide to how interest rate swaps work in the Rate Swap Protocol.

What is an Interest Rate Swap?

An Interest Rate Swap (IRS) is a financial derivative where two parties exchange interest payment obligations. In traditional finance:

• One party pays a fixed rate (e.g., 5% annually)
• The other pays a floating rate (e.g., SOFR + 1%)
• Exchanges happen periodically over the swap's lifetime
• Used for hedging, speculation, or managing interest rate risk

How Rate Swap Protocol Works

The protocol implements on-chain, margined IRS with these characteristics:

Margined Positions

Instead of full notional exchange, traders post collateral:

• Initial Margin: Required to open position
• Maintenance Margin: Minimum to avoid liquidation
• More capital efficient than traditional swaps

Mark-to-Market Settlement

Positions are continuously valued:

• Funding Index: Tracks cumulative rate movements
• MTM Calculation: Real-time unrealized P&L
• Settlement: Periodic funding adjustments

Oracle-Based Rates

Rates come from trusted oracles:

• Rate Index: E.g., perp funding, borrow APR
• Updates: Authority-controlled, regular intervals
• Staleness Checks: Ensures fresh data

Position Mechanics

Entry

When you open a position:

1. Specify notional and direction
2. AMM quotes implied fixed rate
3. Initial margin checked
4. Position created with entry rate and funding index snapshot

During Position Lifetime

As rates fluctuate:

• Funding settles: funding_delta = notional × (F_now - F_last)
• MTM updates: Based on current rate vs entry rate
• Health monitored: health = collateral + MTM - maintenance_requirement

Exit

Close position by:

• Executing opposite swap (reverses notional to zero)
• Realizes P&L into collateral balance
• Releases margin requirements

P&L Calculation

Funding P&L

Cumulative_Funding_PnL = notional_wad × (Current_F - Entry_F)

Where F is the cumulative funding index.

Mark-to-Market P&L

MTM_PnL = (current_rate - entry_rate) × notional × time_to_maturity / SECONDS_PER_YEAR

Total P&L

Total_PnL = Funding_PnL + MTM_PnL

Example Trade

Scenario: You expect rates to rise

1. Open Position:

   • Notional: +100,000 (pay fixed, receive floating)
   • Entry Rate: 5% fixed
   • Initial Margin: $5,000 (5% of notional)

2. Rates Rise to 6%:

   • MTM Profit: (0.06 - 0.05) × 100,000 × time_factor ≈ $1,000
   • Health improves due to unrealized gain

3. Funding Settlements:

   • As floating rate index increases, you receive funding
   • Realized P&L accumulates in collateral balance

4. Exit:

   • Close position at 6% rate
   • Realize profits + release margin

Risk Factors

Market Risk

• Rates move against your position
• MTM losses reduce health
• Potential liquidation if health < 0

Funding Risk

• Adverse funding settlements drain collateral
• High rate volatility increases funding payments

Liquidity Risk

• Large positions may have price impact
• Pool liquidity constrains available notional

Oracle Risk

• Stale oracle data halts trading
• Oracle manipulation could affect settlement

Advanced Concepts

DV01

Dollar Value of a Basis Point: How much position value changes per 0.01% rate move.

DV01 ≈ notional × time_to_maturity / (100 × SECONDS_PER_YEAR)

Used for risk management and position sizing.

Convexity

Interest rate positions have convexity (non-linear P&L). Large rate moves have accelerated P&L impact.

Curve Trading

Future enhancement: Trade swaps across different maturities to express curve views (steepening, flattening).

Next Steps

• Risk Management - Manage your exposure
• Engineering Architecture - Technical implementation
• Business Risk Framework - Protocol-level risk