Trade on Interest Rates

Learn how and why to trade Interest Rate Swaps

How to Trade Interest Rate Swaps: A Step-by-Step Guide

Understanding the Basics

Before you start trading, understand what you're doing:

• Pay Fixed, Receive Variable: You think rates will go UP

• Pay Variable, Receive Fixed: You think rates will go DOWN

• Notional Amount: The size of your position (you don't need to deposit the full amount)

• Collateral: What you actually deposit to back your position

Step 1: Choose Your Market

Interest rate swap markets are created with specific parameters:

• Reference Rate: Which rate you're betting on (Aave USDC borrow rate, Hyperliquid BTC funding rate, etc.)

• Term Length: How long the swap lasts (1 day, 3 months, 1 year, etc.)

• Collateral Token: What you deposit to secure your position

Example Markets:

• 1-day Aave USDC borrow rate (collateral: USDC)

• 90-day Aave USDT borrow rate (collateral: USDT)

• 1-day Hyperliquid BTC funding rate (collateral: USDC)

Step 2: Determine Your Position Size

Key Concepts:

• Notional Amount: The swap size (e.g., $100,000)

• Collateral Required: Typically a fraction of notional

• Leverage: Notional ÷ Collateral = Your leverage multiplier

Example:

• A 1 month swap for $100,000 notional may have a base collateral requirement of $500. With a market leverage multiplier of 2, the total collateral required for the $100,000 swap would be $250 (or $500/2).

Interest rate swaps are leveraged instruments. Your collateral requirement is determined by your expected payments for the swap's term and then adjusted based on the market's leverage multiplier. Shorter tenor markets will generally enable much higher leverage.

Step 3: Choose Your Direction

Bullish on Rates (Expect rates to RISE)

Position: Pay Fixed, Receive Variable

• You pay a fixed rate (e.g., 5%)

• You receive whatever the variable rate becomes

• Profit if: Variable rate goes above your fixed rate

• Loss if: Variable rate stays below your fixed rate

Example:

• Current Aave rate: 4%

• You pay fixed 5%, receive variable

• If the time-weighted average rate (TWAR) of Aave for the swap term is 8%, you earn 3% on your notional

Bearish on Rates (Expect rates to FALL)

Position: Pay Variable, Receive Fixed

• You pay whatever the variable rate is

• You receive a fixed rate (e.g., 4%)

• Profit if: Variable rate falls below your fixed rate

• Loss if: Variable rate rises above your fixed rate

Example:

• Current Aave rate: 6%

• You pay variable, receive fixed 4%

• If the time-weighted average rate (TWAR) of Aave for the swap term is 2%, you earn 2% on your notional

Step 4: Execute Your Trade

Through the Protocol Interface:

1. Connect Wallet: Use MetaMask, WalletConnect, etc.

2. Select Market: Choose your reference rate and term

3. Enter Position Details:

   • Notional amount

   • Direction (pay fixed/receive variable or vice versa)

   • Review the fixed rate being offered

4. Approve Collateral: Allow the protocol to use your tokens

5. Submit Transaction: Confirm the swap creation

Key Elements:

• Reference Rate: Current variable rate for a given market

• Current Fixed Rate: Fixed rate for a given market at a point in time

  • The pool fees will be accounted for in the fixed rate you pay or receive

• Collateral Requirement: How much you need to deposit

• Liquidation Risk: When your position might get closed

Step 5: Monitor Your Position

What to Watch:

• Current Variable Rate: How the reference rate is moving and its TWAR for the term

• Unrealized P&L: Your current profit/loss

• Collateral Ratio: Make sure you don't get liquidated

• Time Decay: How much time is left on your swap

Managing Risk:

• Close Early: Exit before expiration if desired. Please be aware there may be fees for closing a swap early.

• Roll Position: Close current swap and open a new one.

Step 6: Settlement

At Expiration:

• Calculate Average Rate: The protocol determines the TWAR of the variable rate and the fixed rate over the term.

• Net Settlement: You pay or receive the difference.

• Collateral Return: Get back your remaining collateral after settlement plus any profits if the net settlement difference was in your favor.

Example Settlement:

• You paid fixed 6%, received variable on $1M notional for 1 months

• Total collateral required is $2500 in USDC

• Average variable rate was 7%

• You receive: (7% - 6%) × $1,000,000 × (1/12) = $830 in profit, or ~33% return on capital

• Plus, your original collateral is returned

Settlement is based on your notional, not your collateral. Profits and losses can be significantly amplified due to the inherent leverage.

Common Strategies

Hedging:

• Lender Protection: You're lending on Aave, worried about rate drops → Pay variable, receive fixed

• Borrower Protection: You're borrowing variable rates, worried about spikes → Pay fixed, receive variable

Speculation:

• Bull Market Play: Expect DeFi rates to spike → Pay fixed, receive variable across multiple markets

• Bear Market Play: Expect rates to crash → Pay variable, receive fixed

• Volatility Play: Trade around major events (Fed meetings, protocol updates, etc.)

Arbitrage:

• Cross-Protocol: If Aave and Compound rates are misaligned

• Term Structure: If short-term and long-term rates seem mispriced

• Basis Trading: Combine with underlying lending positions

Risk Management Tips

1. Start Small: Use lower leverage until you understand the mechanics

2. Diversify: Don't put all capital in one rate/term

3. Watch Liquidations: Keep collateral ratios healthy

4. Understand Correlation: DeFi rates often move together

5. Monitor Gas: Factor in transaction costs for smaller positions

6. Time Decay: Longer terms give more time to be right, but tie up capital longer

Advanced Features

• Partial Closing: Exit part of your position early

• Rolling: Close and reopen in new terms

• Portfolio View: Manage multiple swaps across different markets

DISCLAIMER: Interest rate swaps are leveraged instruments. You can lose all of you initial collateral if positions move significantly against you. Always understand the risks before trading.