Financial Management · Hedging techniques for interest rate risk

Interest Rate Swaps for ACCA FM Explained

Updated 11 October 2026 · Fact-checked

An interest rate swap is an agreement between two parties to exchange interest payments on the same notional principal, usually fixed for floating. No principal changes hands. To solve a question, work out each party's cost with and without the swap, then compare. Any saving is the net effect.

Understand Interest Rate Swaps

An interest rate swap lets two parties swap the nature of their interest payments. One pays a fixed rate and receives a floating rate. The other does the opposite. The notional principal is only used to calculate the payments. It is never exchanged.

Why do it? A company with floating rate debt fears rates will rise. It can swap into fixed and know its cost. A company with fixed rate debt that expects rates to fall can swap into floating. A swap changes the interest cost without repaying the original loan. The original loan stays in place and the lender is still paid by the borrower.

A plain vanilla swap exchanges fixed for floating, with both based on the same currency and the same floating index. A basis swap exchanges one floating rate for another floating rate, for example one based on a bank's base rate against one based on a market reference rate. A basis swap manages the gap between two floating rates, not fixed versus floating risk.

Swaps can also create savings through comparative advantage. Suppose a strong credit company and a weaker credit company both want to borrow. The weaker one pays a higher rate in both markets. But the gap between the two is usually smaller in one market than the other. Each borrows where it has the relative advantage, then they swap. The total saving is shared between them, and a bank intermediary may take a fee out of it.

In practice, only the net difference between the fixed and floating payments is settled at each date. The swap does not remove the credit risk of the counterparty. If the other side defaults, you may lose the benefit of the swap.

Key rules to remember

Net cost with a swap: Net cost = interest paid to lender + swap payment − swap receipt (+ or − any fee); Do this separately for each party, and state the answer as a fixed or floating rate.
Total comparative advantage saving: Saving = |fixed rate gap − floating rate gap|; Fixed rate gap is the difference between the two companies' fixed rates. Floating rate gap is the difference between their floating spreads over the same base. Use the same units.
Saving per party: Share of saving = (total saving − bank fee) × agreed share (often 50% each), unless the question states how the fee is borne; Deduct the bank fee from the total saving first if the question says the fee is paid out of the gains.
Swap saving in money: Annual saving (₹) = rate saving × notional principal; Convert the percentage saving into money only if asked.
Plain vanilla vs basis swap: Plain vanilla = fixed ↔ floating. Basis = floating ↔ floating on different bases.; Learn this as a definition for short written parts.

How to solve Interest Rate Swaps questions

Use this order for any swap question, whether it is an objective test case or a written Section C part.

1Write down each company's borrowing rates in the fixed market and the floating market, and note which type of debt each wants.
2Calculate the gap between the two companies in the fixed market and in the floating market. The difference between the gaps is the total saving available.
3Decide where each company should borrow. The stronger company borrows in the market where its comparative advantage is greatest. The weaker company borrows in the market where its disadvantage is smallest.
4Deduct any bank fee from the total saving, then split the remainder as the question says (often equally).
5Set the swap terms so that each company gains its share. Work backwards from the target net cost.
6Prove the result. For each company, add its actual interest paid to the lender and its swap payments, then subtract swap receipts. Compare with its cost if it borrowed directly.
7State the outcome clearly: the net rate, the saving in percentage points and, if asked, the saving in money using the notional principal.
8Add a brief comment on risks if asked, such as counterparty default or rates moving the other way.

Quickest way: Gap method for comparative advantage

When to use it: Use when you are given two companies, two markets and asked for the total or shared saving.

Subtract the two fixed rates to get the fixed gap.
Subtract the two floating spreads to get the floating gap.
Take the difference between the two gaps. That is the total saving.
Subtract any fee, then divide by the share given.
Check the answer by building one company's net cost as a final step.

Common mistakes in Interest Rate Swaps

Treating the notional principal as if it is exchanged
Swaps sound like loans, so students expect cash to move at the start and end.
Fix: State that the principal is notional. Only interest is calculated on it, and usually only the net amount is paid.
Comparing the rates instead of the gaps
Students notice that one company is cheaper in both markets and conclude no swap is possible.
Fix: Always compute the gap in each market. A saving exists whenever the two gaps are different.
Forgetting to deduct the bank fee before splitting the saving
The fee is mentioned late in the question and gets missed.
Fix: Underline any fee at the start. Subtract it from the total saving, or follow the wording on who bears it.
Mixing up floating spreads and fixed rates
A floating rate such as base + 1.0% looks different from a fixed rate such as 6.5%.
Fix: Compare spreads with spreads and fixed with fixed. Convert to the same base before you take any gap.
Confusing a basis swap with a plain vanilla swap
Both are called interest rate swaps and the names sound alike.
Fix: Plain vanilla swaps fixed for floating. A basis swap exchanges two floating rates on different bases.
Ignoring that the loan with the lender stays in place
Students think the swap replaces the original borrowing.
Fix: Include the interest paid to the lender in each company's net cost, then add the swap flows.

Worked examples

Example 1

Company A (strong credit) can borrow fixed at 5.0% or floating at base + 0.5%. Company B (weaker credit) can borrow fixed at 6.5% or floating at base + 1.5%. A wants floating debt. B wants fixed debt. A bank is not involved and the gain is shared equally. Calculate the total saving and each company's net cost.

Show the solution

Fixed gap = 6.5% − 5.0% = 1.5%.
Floating gap = (base + 1.5%) − (base + 0.5%) = 1.0%.
Total saving = 1.5% − 1.0% = 0.5%.
Each company gets half: 0.25%.
A's comparative advantage is greatest in fixed (1.5% against 1.0% in floating), so A borrows fixed at 5.0%. B's disadvantage is smallest in floating, so B borrows floating at base + 1.5%.
A wants floating. Without a swap A would pay base + 0.5%. Target is base + 0.5% − 0.25% = base + 0.25%.
B wants fixed. Without a swap B would pay 6.5%. Target is 6.5% − 0.25% = 6.25%.
Set the swap: B pays A fixed 5.0% on the notional principal; A pays B floating at base + 0.25%.
Check A: pays lender 5.0%, receives 5.0% from B, pays base + 0.25% to B. Net = base + 0.25%, which meets the target.
Check B: pays lender base + 1.5%, receives base + 0.25% from A, pays 5.0% to A. Net = base + 1.5% + 5.0% − (base + 0.25%) = 6.25%, which meets the target.

Answer: Total saving is 0.5%. A pays base + 0.25% and B pays 6.25%, each saving 0.25%.

Example 2

A company has a ₹20,00,00,000 floating rate loan at base + 1.0%. It enters a swap in which it pays 6.0% fixed and receives base. Base is currently 5.0%. Calculate the company's net interest rate and the annual interest cost in rupees. Then say what happens if base rises to 7.0%.

Show the solution

Interest to the lender = base + 1.0%.
Swap: pays 6.0% fixed, receives base.
Net rate = (base + 1.0%) + 6.0% − base = 7.0%.
The base cancels, so the net rate is fixed at 7.0%.
Annual cost = 7.0% × ₹20,00,00,000 = ₹1,40,00,000.
If base rises to 7.0%: lender gets 8.0%, swap receipt is 7.0%, swap payment is 6.0%.
Net = 8.0% + 6.0% − 7.0% = 7.0%. The cost is unchanged.

Answer: The net rate is 7.0% fixed, which is ₹1,40,00,000 a year. It stays at 7.0% if base rises to 7.0%.

Exam tips

Show the check for each company. Many Section C marks are for the net cost proof, not just the saving figure.
In objective questions, calculate the two gaps first. Most answer options are built from common errors such as using one gap alone.
Always state whether the final result is a fixed or floating rate and whether it is better than borrowing directly.
If a written part asks for risks, mention counterparty default and the loss of benefit if rates move the other way.
Read the wording on who pays the bank fee and how the saving is shared. Do not assume an equal split.

Practice questions from Hedging techniques for interest rate risk

Interest Rate Swaps in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Interest Rate Swaps: frequently asked questions

What is the difference between a plain vanilla swap and a basis swap?

A plain vanilla swap exchanges a fixed rate for a floating rate. A basis swap exchanges one floating rate for another floating rate based on a different reference. The first manages fixed versus floating risk. The second manages the gap between two floating bases.

How do you calculate interest rate swap savings in ACCA FM?

Find the gap between the two companies in the fixed market and the gap in the floating market. The difference between those gaps is the total saving. Deduct any bank fee, then split what is left as the question states.

Is the principal exchanged in an interest rate swap?

No. The principal is notional and only used to calculate the interest. Usually only the net difference between the two interest amounts is paid at each settlement date.

Does a swap replace the original loan?

No. The original loan with the lender stays in place and the company still pays that interest. The swap is a separate contract that changes the net cost of the borrowing.