Advanced Financial Management · Foreign Exchange Exposure and Risk Management

Currency Swaps and Interest Rate Swaps for CA Final AFM

Updated 5 October 2026 · Fact-checked

A swap is an agreement to exchange cash flows on a notional amount. An interest rate swap exchanges fixed and floating interest in one currency, with no principal exchange. A currency swap exchanges principal and interest in two currencies. To solve, list each party's flows, convert at the stated rates, add them up, and compare with the unhedged cost.

Understand Currency Swaps and Interest Rate Swaps

A swap is a contract between two parties to exchange a series of cash flows on agreed dates. The cash flows are worked out on an agreed notional principal. Swaps are used because a firm often borrows in the market where it is cheap or well known, but needs a different currency or interest basis.

In a plain vanilla interest rate swap, both legs are in the same currency. One party pays a fixed rate and the other pays a floating rate (such as MIBOR or SOFR) on the same notional. The notional is never exchanged. Only the net interest difference is paid on each date. The swap changes how you pay interest. It does not change the loan itself.

In a currency swap, the two legs are in different currencies. The parties usually exchange principal at the start at the spot rate. They then pay interest to each other in the respective currencies. At maturity they re-exchange the principal at the same initial rate. This fixed re-exchange rate removes the exchange rate risk on the principal and the interest. Interest can be fixed on both legs, floating on both, or fixed on one and floating on the other. The last case is a cross-currency interest rate swap.

Swaps also exploit comparative advantage. A stronger borrower usually has a bigger spread advantage in fixed-rate markets than in floating-rate markets. The difference between the two spreads is the total gain from the swap. The parties share that gain, usually equally unless the question says otherwise.

The key difference for exams: an interest rate swap has one currency, no principal exchange, and net settlement. A currency swap has two currencies, normally exchanges principal at start and end, and carries the exchange rate fixed in the contract. Always check whether the question settles net or gross.

Key rules to remember

Net payment in an interest rate swap: Net payment = Notional × (Fixed rate − Floating rate) × days ÷ 360; Use the day count or period fraction given in the question. For annual settlement, use 1. A positive figure is paid by the fixed payer.
Total gain from swap (comparative advantage): Total gain = |Fixed-rate spread difference − Floating-rate spread difference|; Spread difference is the higher borrower's rate minus the lower borrower's rate, in each market. Share the gain equally unless told otherwise.
Post-swap cost of a party: Cost = Rate paid to lender + Rate paid to counterparty − Rate received from counterparty; Do this for each party and check that the total saving equals the total gain.
Principal exchange in a currency swap: Foreign principal = Domestic principal ÷ Spot rate (₹ per unit of foreign currency); Use the same rate for the re-exchange at maturity. The contract fixes it. Later spot rates do not matter for the swapped flows.
Interest on each leg of a currency swap: Interest = Principal in that currency × Rate of that leg × period fraction; Compute each leg in its own currency. Convert to rupees only when comparing, and use the rate that applies to that date.
Rupee cost of unhedged foreign loan: Rupee outflow = Foreign currency outflow × Spot rate on payment date; Compare this with the swapped rupee outflow to measure the benefit of the swap.

How to solve Currency Swaps and Interest Rate Swaps questions

Use the same sequence for any swap question. Write it out as a small table of dates against flows. This keeps the signs right and earns method marks.

1Identify the type: interest rate swap (one currency), currency swap (two currencies) or cross-currency interest rate swap. Note the notional, tenor, settlement dates and day count.
2Write down who borrows what from the market, and at what rate. Then write what each party wants (fixed or floating, rupee or dollar).
3For a comparative advantage question, find the spread difference in the fixed market and in the floating market. The gap between them is the total gain. Split it as instructed.
4Set the swap terms so that each party's final cost equals its direct cost minus its share of the gain. Solve for the unknown rate or payment.
5For a currency swap, convert the principal at the stated spot rate. Then list the initial exchange, each interest payment in each currency, and the final re-exchange at the same rate.
6Compute net cash flows for each date and each party. Show the sign clearly: outflow in brackets, inflow without.
7Compare with the unhedged position or the direct borrowing cost. Use the forward or expected spot rates given in the question.
8State the conclusion in one line: effective cost, saving, and whether the swap is worth doing.

Quickest way: Cost-equation shortcut for swap questions

When to use it: Use when the question asks for the swap rate, the effective cost after the swap, or the saving to each party, and you have little time.

Compute the total gain: fixed spread difference minus floating spread difference. Take the positive figure.
Divide the gain by the sharing ratio, usually equally, to get each party's saving.
Write each party's target cost: direct cost minus saving.
Write the cost equation: loan rate + rate paid − rate received = target cost. Solve for the unknown swap rate.
Verify: the two final costs together must be lower than the two direct costs by exactly the total gain.
For currency swaps, skip the ongoing conversions. Multiply the foreign interest and principal by the contracted rate once, and compare with the unhedged conversion at the forecast spot.

Common mistakes in Currency Swaps and Interest Rate Swaps

Exchanging the notional principal in an interest rate swap
Students mix up interest rate swaps with currency swaps, where principal does change hands.
Fix: In a same-currency interest rate swap, the notional is only a reference. Show only interest or net interest flows.
Using today's spot or the forecast spot to re-exchange principal in a currency swap
Students convert every flow at the rate prevailing on that date out of habit.
Fix: The swapped principal comes back at the initial rate fixed in the contract. Use the forecast rate only for the unhedged comparison.
Computing the gain by adding the spreads instead of subtracting
The two spread differences look like two separate benefits.
Fix: Total gain is the difference between the fixed-market spread and the floating-market spread. If they are equal, there is no gain.
Getting the direction of the swap wrong
Students do not check which party borrows in which market before setting up the swap.
Fix: Each party borrows where it has the comparative advantage, then swaps into the interest basis it wants. Check that each ends up with the exposure it asked for.
Forgetting the period fraction or day count
Annual rates are applied directly to half-yearly or quarterly flows.
Fix: Multiply by the period fraction (for example 6 ÷ 12 or days ÷ 360) before computing each payment.
Ignoring the sign of net payments and leaving out the conclusion
Students rush through the arithmetic and stop at a number.
Fix: Label every flow as paid or received, and end with a statement of effective cost and saving versus the alternative.

Worked examples

Example 1

An Indian company has a 3-year USD 10,00,000 loan from a foreign lender at 5% p.a., interest paid annually, principal repaid at the end of year 3. Spot is ₹80 per USD. The company enters a currency swap with a bank: at the start the company gives the USD loan proceeds to the bank and receives ₹8,00,00,000 (the bank's rupee leg); each year the company pays the bank 9% on ₹8,00,00,000 and receives 5% on USD 10,00,000. At maturity, the principal is re-exchanged at ₹80. The company's USD loan is serviced out of the USD it receives from the bank. If the spot rate at the end of year 3 is ₹84, compare the company's year-3 outflow with and without the swap. Ignore the effect of earlier years.

Show the solution

By handing the USD loan proceeds to the bank for ₹8,00,00,000 at the start, the company turns its USD loan into a rupee loan of ₹8,00,00,000 at 9%. The bank's USD receipts and payments match the loan servicing, so the company has no USD exposure left.
The swap receipts in USD match the loan servicing: interest USD 10,00,000 × 5% = USD 50,000 a year, and USD 10,00,000 principal at maturity.
With the swap, year-3 outflow in rupees = interest ₹8,00,00,000 × 9% + principal ₹8,00,00,000 = ₹72,00,000 + ₹8,00,00,000 = ₹8,72,00,000.
Without the swap, the company keeps its USD loan. Year-3 outflow in USD = USD 50,000 + USD 10,00,000 = USD 10,50,000.
Converted at ₹84: 10,50,000 × 84 = ₹8,82,00,000.
Difference for year 3 only = ₹8,82,00,000 − ₹8,72,00,000 = ₹10,00,000 saved.

Answer: With the swap the company effectively holds a ₹8,00,00,000 loan at 9%, so its year-3 outflow is ₹8,72,00,000. Unhedged, the year-3 outflow would be ₹8,82,00,000. On this year-3 comparison alone, the swap saves ₹10,00,000. The swapped rupee outflow stays the same whatever the year-3 spot rate is. If the rupee had strengthened instead, the unhedged outflow would have been lower and the swap would have cost more, so the benefit is certainty, not guaranteed savings.

Example 2

Company A is highly rated and can borrow fixed at 7% or floating at MIBOR + 0.30%. Company B is lower rated and can borrow fixed at 8.50% or floating at MIBOR + 1.00%. A wants floating-rate funds. B wants fixed-rate funds. Both need ₹50,00,00,000. They agree to share the total swap gain equally. Design the swap and compute each company's annual saving.

Show the solution

Fixed-market spread difference = 8.50% − 7.00% = 1.50%. Floating-market spread difference = 1.00% − 0.30% = 0.70%.
Total gain = 1.50% − 0.70% = 0.80%. Each party's share = 0.40%.
A has the greater advantage in the fixed market, so A borrows fixed at 7%. B borrows floating at MIBOR + 1.00%.
A's target cost = (MIBOR + 0.30%) − 0.40% = MIBOR − 0.10%. B's target cost = 8.50% − 0.40% = 8.10%.
Let the fixed rate that B pays A be x. Swap: A pays B floating at MIBOR. B pays A fixed at x.
A's cost = 7% + MIBOR − x = MIBOR − 0.10%. So x = 7.10%.
B's cost = (MIBOR + 1.00%) + 7.10% − MIBOR = 8.10%. This matches the target.
Annual saving to each = 0.40% × ₹50,00,00,000 = ₹20,00,000. Total = ₹40,00,000, which equals 0.80% of the notional.

Answer: A borrows fixed at 7%, B borrows floating at MIBOR + 1.00%. Under the swap, A pays B MIBOR and B pays A 7.10% fixed. A's effective cost is MIBOR − 0.10% and B's is 8.10% fixed. Each saves 0.40%, which is ₹20,00,000 a year.

Exam tips

Practical questions often come as case scenarios. Read for who borrows where and what each party wants before touching numbers.
Draw a small cash flow diagram for every swap: two boxes, arrows for flows, labels with rates. Examiners give marks for correct structure.
In a currency swap, state clearly that principal is re-exchanged at the contracted rate. This one line often carries a mark.
Always finish with a comparison to the unhedged or direct borrowing position. Check that your gains reconcile with the total gain.
For theory, be ready to state the difference between interest rate swaps and currency swaps in a few points: currencies, principal exchange, settlement, and risk hedged.

Practice questions from Foreign Exchange Exposure and Risk Management

Currency Swaps and 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.

Currency Swaps and Interest Rate Swaps: frequently asked questions

What is the difference between an interest rate swap and a currency swap?

An interest rate swap exchanges fixed and floating interest in the same currency. The notional is not exchanged and only net interest is settled. A currency swap involves two currencies and usually exchanges principal at the start and at maturity, besides interest payments.

How does a currency swap protect against exchange rate risk?

The principal is re-exchanged at the rate fixed on day one, and interest in each currency is set by the contract. So the borrower's cost in its own currency is known in advance. Later movements in the spot rate do not change the swapped flows.

What is a cross-currency interest rate swap?

It is a currency swap in which one leg pays a fixed rate and the other a floating rate, in different currencies. It lets a borrower change both the currency and the interest basis of a loan in one contract.

How do I split the gain in a swap question?

Find the fixed-market spread difference and the floating-market spread difference. Subtract the smaller from the larger to get the total gain. Divide it as the question says. If nothing is stated, share it equally.