A swap is an agreement between two parties to exchange streams of cash flows over a period. The most common is the interest rate swap, in which one party pays a fixed rate and receives a floating rate on the same notional amount. Currency swaps exchange cash flows in two different currencies. Swaps are among the largest derivative markets in the world, used by companies, banks and governments to reshape their exposure to interest rates and currencies without changing their underlying loans or investments.
What you will learn
- Explain how a plain-vanilla interest rate swap works
- Calculate net swap payments
- Explain how currency swaps work and why they are used
- Understand how swaps are valued and the risks they carry
The interest rate swap
In a plain-vanilla interest rate swap:
- the fixed-rate payer pays a fixed rate on a notional principal;
- the floating-rate payer pays a floating rate, reset periodically from a reference rate;
- the notional principal is not exchanged — it is only used to calculate payments;
- payments are usually netted: only the difference changes hands on each payment date.
Worked example: net swap payments
A company has a 10,000,000 floating-rate loan and enters a 3-year swap in which it pays a fixed 8.0% and receives the floating reference rate, with annual settlement (illustrative figures).
| Year | Floating rate | Company pays (fixed) | Company receives (floating) | Net payment by company |
|---|---|---|---|---|
| 1 | 7.5% | 800,000 | 750,000 | 50,000 |
| 2 | 8.6% | 800,000 | 860,000 | −60,000 (it receives 60,000) |
| 3 | 9.2% | 800,000 | 920,000 | −120,000 (it receives 120,000) |
On its loan, the company pays the floating rate plus its credit margin. The swap’s floating receipts offset the floating loan interest, so the company’s effective cost is the swap’s fixed 8.0% plus its loan margin — its interest cost is now fixed, whatever happens to rates.
Why use an interest rate swap?
- Converting floating to fixed — a borrower that expects rates to rise, or simply wants certainty for budgeting, swaps its floating-rate loan to fixed (as above).
- Converting fixed to floating — an issuer of fixed-rate bonds that expects rates to fall, or wants to match floating-rate assets, receives fixed and pays floating.
- Asset-liability management — banks use swaps to align the interest rate sensitivity of assets and liabilities, managing the interest rate risk described in market risk.
- Lower cost of borrowing — a company may borrow where it has an advantage (for example in the floating-rate loan market) and use a swap to obtain the exposure it wants.
Currency swaps
In a currency swap, two parties exchange principal and interest in different currencies:
- At the start, they usually exchange principal amounts at the current exchange rate.
- During the swap, each pays interest on the principal it received — fixed or floating in each currency.
- At maturity, they re-exchange the principal amounts at the original rate.
Worked example: hedging a dollar loan
A company borrows USD 1,000,000 at 6% fixed for three years but earns its revenue in local currency. The spot rate is 120 (illustrative figures). It enters a currency swap with a bank:
- Start: it gives the bank USD 1,000,000 and receives 120,000,000 in local currency.
- Each year: it pays the bank local-currency interest (say 10% on 120,000,000 = 12,000,000) and receives USD 60,000, which it uses to pay its dollar lender.
- Maturity: it pays back 120,000,000 and receives USD 1,000,000 to repay the loan.
Its debt service is now entirely in local currency at a known cost, protected from exchange-rate movements. The higher local-currency rate reflects the interest rate difference between the two currencies.
How swaps are valued
At the start, a swap’s fixed rate is set so that its value is close to zero for both sides — the present value of the expected floating payments equals the present value of the fixed payments. Afterwards, as interest rates move, the swap gains value for one party and loses it for the other. A swap can be valued as the difference between a fixed-rate bond and a floating-rate bond, or as a series of forward contracts, discounting expected cash flows with the yield curve. Under IFRS 9, derivatives are measured at fair value, and companies may apply hedge accounting when they meet its conditions.
Risks of swaps
- Counterparty credit risk — the other party may default when the swap is valuable to you. Collateral agreements and central clearing reduce this.
- Market risk — if you have not hedged an underlying exposure, a swap is a speculative position.
- Basis risk — the swap’s reference rate may not match the loan’s.
- Liquidity and early termination costs — closing a swap early means paying or receiving its market value.
- Legal and documentation risk — swaps are usually documented under standard industry agreements; terms must be understood.
Benchmark transition
Many swaps referenced interbank offered rates (IBORs) such as LIBOR. After concerns about how those rates were set, major markets moved to overnight risk-free reference rates. Contracts must specify the reference rate and what happens if it ceases to be published.
Common mistakes
- Thinking the notional principal is exchanged in an interest rate swap.
- Ignoring the credit margin on the underlying loan when calculating the all-in fixed cost.
- Treating a swap as a hedge when there is no matching underlying exposure.
- Underestimating the cost of terminating a swap early.
Key terms
- Interest rate swap — exchange of fixed and floating interest payments on a notional amount.
- Currency swap — exchange of principal and interest in two currencies.
- Notional principal — the reference amount used to calculate swap payments.
- Netting — paying only the difference between the two sides’ obligations.
- Fixed-rate payer — the party that pays fixed and receives floating.
Frequently asked questions
Does a swap change my loan agreement?
No. The loan continues as before; the swap is a separate contract whose payments offset part of the loan’s interest.
What happens if interest rates fall after I swap to fixed?
You keep paying the fixed rate, so you miss the benefit of lower rates. The swap has a negative value for you, but your total cost remains as planned.
Who uses currency swaps?
Companies with foreign-currency debt or investments, banks managing currency funding, and central banks arranging liquidity lines with each other.
Key takeaways
- An interest rate swap exchanges fixed and floating payments on a notional amount; only net payments are made.
- Swaps let borrowers convert floating-rate debt to fixed, or vice versa, without changing the loan.
- Currency swaps exchange principal and interest in two currencies, hedging currency mismatches.
- Swaps are valued from the yield curve and carry counterparty, basis and termination risks.