Advanced Financial Management · The use of financial derivatives to hedge against interest rate risk

Interest Rate Swaps for ACCA AFM

Updated 11 October 2026 · Fact-checked

An interest rate swap is an agreement to exchange interest payments on a notional amount, usually fixed for floating, without swapping the principal. To solve questions, find each party's borrowing rates, calculate the net saving from the rate differentials, deduct any bank fee, share the gain, then set the swap rates so each party's net cost shows its share.

Understand Interest Rate Swaps

A company with floating-rate debt is exposed to rising interest rates. A company with fixed-rate debt may be stuck paying more than the market if rates fall. An interest rate swap lets each change the type of interest it pays without touching the original loan.

In a plain vanilla swap, two parties agree to exchange interest on a notional principal. One pays a fixed rate and receives a floating rate. The other does the opposite. The principal is never exchanged. It is only used to work out the interest. Usually only the net difference is paid on each settlement date.

The original loans stay in place. The swap sits on top of them. Your loan interest goes to the lender, and the swap payments go to or from the counterparty. Add the two together to find your net cost. A floating borrower who pays fixed on a swap and receives floating has effectively turned the debt into fixed-rate debt.

Swaps can also create a gain. This is the comparative advantage idea. Two companies borrow at different rates in the fixed and floating markets. The gap between those two differentials is not the same for each company. If each borrows where it has the comparative advantage and they then swap, the total interest cost falls. That saving is shared between them. A bank usually acts as intermediary and takes a fee out of the saving.

A swaption is an option on a swap. The buyer pays a premium for the right, but not the obligation, to enter a swap at a set fixed rate on or by a future date. It suits a company that is unsure whether it will need the swap, for example because a loan or a bid is not yet confirmed. If rates move favourably, the company lets the swaption lapse and loses only the premium.

Key rules to remember

Net saving from comparative advantage: Net saving = |Fixed rate differential − Floating rate differential|; Differential = the difference between the two companies' rates in that market. Compute both, then take the gap between them.
Gain after bank fee: Gain to share = Net saving − Bank fee; If the bank fee is quoted as a total, deduct it before sharing. Share equally unless the question says otherwise.
Net cost with a swap (payer of fixed): Net cost = Loan interest + Fixed paid on swap − Floating received on swap; If the loan is floating and the floating received matches it, the floating parts cancel and the cost becomes fixed.
Net cost with a swap (payer of floating): Net cost = Loan interest + Floating paid on swap − Fixed received on swap; Use this for the party that wants floating exposure.
Annual swap cash flow: Cash flow = Notional principal × rate difference × (months ÷ 12); Use the rate difference for the net settlement. Adjust for the period length if payments are not annual.
Swaption outcome: Exercise only if the market swap rate is worse than the swaption's strike rate; The premium is paid either way. Compare the outcome with and without the swaption.

How to solve Interest Rate Swaps questions

Use this method for any swap question, whether it is a simple hedge or a comparative advantage swap with a bank fee.

1Identify what each party wants: fixed or floating. Note the notional amount and the loan terms.
2Write down each party's fixed and floating borrowing rates in a small grid.
3Calculate the differential in each market. Take the gap between the two differentials. That is the total saving.
4Deduct any bank fee. Share what is left as the question directs, usually equally.
5Work out the target net cost for each party: the rate it would pay without the swap less its share of the gain.
6Decide who borrows where. Each party borrows in the market where its comparative advantage lies.
7Set the swap payments so each party's loan interest plus swap payments equals its target cost. Check that the bank's receipts less payments equal the fee.
8Convert the percentage gains into currency using the notional amount, and comment on risks such as counterparty default and whether the swap matches the loan term.

Quickest way: Differential grid and cost check

When to use it: Use this for comparative advantage questions when you are short of time and the swap rates must be set.

Draw a two-by-two grid of the fixed and floating rates for both companies.
Subtract down each column to get the two differentials. The gap between them is the total saving.
Subtract the fee. Halve the result and subtract each half from that party's no-swap cost to get target costs.
Fix the floating leg at the market rate paid and received, so it cancels. Solve for the one fixed rate each party pays or receives.
Check by adding loan interest and swap flows for each party. They must equal the target costs, and the bank's fixed difference must equal the fee.

Common mistakes in Interest Rate Swaps

Subtracting the wrong rates, such as comparing one company's fixed rate with the other's floating rate.
The rates sit in a table and it is easy to read across instead of down.
Fix: Always compute differentials within the same market: fixed minus fixed, floating minus floating. Then compare those two gaps.
Forgetting to deduct the bank fee before sharing the gain.
Students share the gross saving first and treat the fee as an afterthought.
Fix: Write 'Saving − fee = gain to share' as a line in your answer. Then share it.
Having each company borrow where it wants the final rate type instead of where it has the comparative advantage.
It feels natural to borrow fixed if you want fixed.
Fix: Borrow in the market of comparative advantage. The swap then converts the debt to the type each party wants.
Treating the notional principal as if it is paid or received.
Confusion with currency swaps, where principal is often exchanged.
Fix: In an interest rate swap, only interest on the notional is exchanged, and normally only the net amount.
Setting swap rates that do not reproduce the target cost, so the numbers do not add up.
No final check of loan interest plus swap flows for each party.
Fix: Finish with a check for each party and the bank. If any one is off, the swap rates are wrong.
Describing a swaption as an obligation, or ignoring its premium.
Mixing it up with a swap itself.
Fix: State that the buyer has the right, not the obligation, and that the premium is paid whether or not it is exercised.

Worked examples

Example 1

Company P wants floating-rate finance and Company Q wants fixed-rate finance. Each needs $50 million. P can borrow fixed at 4.0% or floating at SOFR + 1.0%. Q can borrow fixed at 6.0% or floating at SOFR + 2.0%. A bank arranges a swap and takes a total fee of 0.2% a year. The net gain after the fee is shared equally. Show how the swap works and the annual dollar gain to each company.

Show the solution

Fixed differential = 6.0% − 4.0% = 2.0%. Floating differential = (SOFR + 2.0%) − (SOFR + 1.0%) = 1.0%.
Total saving = 2.0% − 1.0% = 1.0%. Less the bank fee of 0.2% leaves 0.8%. Each company gets 0.4%.
P has the comparative advantage in fixed, since its fixed advantage of 2.0% is bigger than its floating advantage of 1.0%. So P borrows fixed at 4.0%. Q borrows floating at SOFR + 2.0%.
Without a swap, P wants floating and pays SOFR + 1.0%. Q wants fixed and pays 6.0%. Targets: P = SOFR + 0.6%. Q = 5.6%.
Set the swap: P pays the bank SOFR and receives 3.4% fixed. P's net cost = 4.0% + SOFR − 3.4% = SOFR + 0.6%. This meets the target.
Q pays the bank 3.6% fixed and receives SOFR. Q's net cost = (SOFR + 2.0%) + 3.6% − SOFR = 5.6%. This meets the target.
Check the bank: it receives 3.6% fixed and pays 3.4% fixed, a net 0.2%. The SOFR it receives from P equals the SOFR it pays to Q, so those cancel. The 0.2% is the fee.
Dollar gain to each company = 0.4% × $50,000,000 = $200,000 a year. The bank earns 0.2% × $50,000,000 = $100,000 a year.

Answer: Each company saves 0.4% a year, which is $200,000. P pays SOFR to the bank and receives 3.4% fixed. Q pays 3.6% fixed to the bank and receives SOFR. The bank keeps 0.2%, or $100,000 a year.

Example 2

A company has a $20 million floating-rate loan at SOFR + 1.2%. It enters a swap in which it pays 4.5% fixed and receives SOFR on $20 million. For one year SOFR is 5.1%. Calculate the net interest cost for the year, show the effective rate, and explain when a swaption might have been better.

Show the solution

Loan interest = (5.1% + 1.2%) × $20,000,000 = 6.3% × $20,000,000 = $1,260,000.
Swap: the company pays 4.5% and receives 5.1%. Net receipt = 0.6% × $20,000,000 = $120,000.
Net interest cost = $1,260,000 − $120,000 = $1,140,000.
Effective rate = $1,140,000 ÷ $20,000,000 = 5.7%. Check: 4.5% fixed on the swap + 1.2% loan margin = 5.7%. The SOFR on the loan and on the swap cancel, so the rate is fixed whatever SOFR does.
Swaption comment: if the company is not sure it will keep the loan, or thinks rates might fall, a swaption lets it pay a premium for the right to enter the swap later. If rates rise, it exercises and fixes the cost. If rates fall, it lets the option lapse and benefits from the lower floating rate, losing only the premium.

Answer: Net interest cost is $1,140,000 for the year, an effective fixed rate of 5.7%. A swaption would give flexibility at the price of a premium, whereas the swap commits the company whatever rates do.

Exam tips

Show the differential grid first. Markers award method marks for the saving calculation even if a later number is wrong.
Always finish with a check that loan interest plus swap flows equal each party's target cost, and that the bank's net equals the fee.
Convert percentage gains into currency using the notional amount, and state whether the figure is per year.
Use the professional skills marks. Comment on counterparty credit risk, the mismatch between swap term and loan term, and whether the saving is worth the risk.
When swaptions or other hedges are mentioned, compare them with the swap. Say who bears the premium and who keeps the benefit if rates move favourably.

Practice questions from The use of financial derivatives to hedge against 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

How do I calculate the gain from an interest rate swap with a bank fee?

Find the fixed and floating differentials between the two companies, then take the gap between them. That is the total saving. Subtract the bank fee and share the remainder as the question states, usually equally.

What is comparative advantage in a swap?

It means each company borrows in the market where its rate disadvantage is smaller or its advantage is greater. The companies then swap into the type of interest they actually want. The combined cost falls because the differentials in the two markets are unequal.

What is a swaption?

A swaption is an option to enter an interest rate swap at a set fixed rate on or before a future date. The buyer pays a premium and can walk away if the swap is no longer wanted or the market rate is better. It is useful when the underlying borrowing is uncertain.

Is the principal exchanged in an interest rate swap?

No. The notional principal is only used to calculate the interest payments. Normally only the net interest difference is settled on each date. This differs from currency swaps, where principal exchange is common.