CFA Level I Exam · Pricing and Valuation of Interest Rate and Other Swaps

Interest Rate Swap Basics and Net Cash Flows

Updated 7 October 2026 · Fact-checked

A plain vanilla interest rate swap is an agreement to exchange fixed-rate interest for floating-rate interest on a notional principal. The notional is never exchanged. On each date you compute both interest amounts, then only the difference is paid, by the party owing more.

Understand Interest Rate Swap Basics and Cash Flows

An interest rate swap is a contract between two parties to exchange interest payments. In a plain vanilla swap, one party pays a fixed rate and receives a floating rate. The other party does the opposite. Both rates apply to the same notional principal, and both legs are in the same currency.

The notional is only a reference amount used to compute interest. It is not lent or repaid. If the notional is USD 10,000,000, no one ever hands over USD 10,000,000. The notional is not exchanged, so it is not a cash flow or a loan.

The fixed leg uses a rate set at initiation, called the swap fixed rate. The floating leg uses a reference rate such as SOFR, plus a spread if the contract says so. The floating rate for a period is usually set in advance (at the start of the period) and paid in arrears (at the end). Each period's swap payment is similar to a forward rate agreement (FRA), with one difference in timing. An FRA settles at the start of the underlying period, at its expiration, on a discounted basis. A swap pays the undiscounted net amount at the end of the period.

On each settlement date, the two amounts are netted. Only one payment is made. The fixed-rate payer pays the net amount if the fixed amount is higher. If the floating amount is higher, the floating-rate payer (the fixed-rate receiver) pays the difference. The fixed-rate payer gains when floating rates rise. Think of the fixed payer as having a position similar to a borrower who converted floating debt to fixed.

A swap can be seen as a series of forward rate agreements, one for each period. Its initial value is zero to both sides, because the fixed rate is set so the present values of the two legs are equal. Pricing the swap fixed rate comes later; this page is about the mechanics.

Key formulas to remember

Fixed leg payment: Fixed payment = Notional × Swap fixed rate × (days in period ÷ days in year); For annual payments, days ÷ year is 1. For semiannual, use 0.5, quarterly 0.25, unless the day count is given.
Floating leg payment: Floating payment = Notional × (Reference rate set at start of period + spread) × (days ÷ year); Use the rate set at the start of the period, not the rate at payment date. Payment is made at period end.
Net payment: Net payment = Notional × (Floating rate − Fixed rate) × period fraction; Positive means the fixed-rate payer receives. Negative means the fixed-rate payer pays.
Initial value: Value at initiation = 0 (PV of fixed leg = PV of floating leg); The swap fixed rate is set so neither party pays upfront.

How to solve Interest Rate Swap Basics and Cash Flows questions

Use this routine for any swap cash flow question. It works for payments, net amounts and who pays whom.

1Identify which party pays fixed and which pays floating. Read the stem carefully.
2Note the notional, the swap fixed rate, the reference rate and any spread.
3Find the period fraction from the payment frequency (annual 1, semiannual 0.5, quarterly 0.25).
4Use the floating rate set at the start of the period, because it is set in advance and paid in arrears.
5Compute the fixed amount and the floating amount on the same notional.
6Subtract to get the net. Fixed payer receives if floating > fixed; otherwise pays.
7Answer from the party's point of view that the question asks about, and check the sign.

Quickest way: Rate difference shortcut

When to use it: Use when the notional and the period are the same for both legs, which is the case in plain vanilla swaps.

Subtract the rates first: floating rate − fixed rate, as a period rate.
Multiply the difference by the notional and the period fraction once.
If the difference is positive, the fixed-rate payer receives. If negative, the fixed-rate payer pays.
Eliminate options that have the wrong direction before checking the size.

Common mistakes in Interest Rate Swap Basics and Cash Flows

Believing the notional principal is exchanged at the end.
Bonds and loans repay principal, so students carry the idea over.
Fix: In a plain vanilla interest rate swap, only interest is exchanged, and only the net amount. The notional is a reference value.
Using the floating rate at the payment date instead of the start of the period.
Students assume the rate that applies is the one prevailing when cash moves.
Fix: Floating is set in advance and paid in arrears. Use the rate observed at the start of the period.
Getting the direction wrong for the fixed payer.
The words pay and receive flip between the two legs.
Fix: Fixed payer receives floating. If floating is above fixed, the fixed payer is the net receiver.
Forgetting to scale the annual rate for a semiannual or quarterly period.
Rates are quoted annually and the period fraction is easy to skip.
Fix: Always multiply by the period fraction. Semiannual means 0.5 unless a day count is given.
Saying the swap has an upfront cost at initiation.
Students confuse swaps with options, which require a premium.
Fix: A fairly priced swap has zero value at initiation, so no upfront payment is made.

Worked examples

Example 1

A company enters a 2-year plain vanilla swap with a notional of USD 20,000,000, paying a fixed rate of 4.00% and receiving SOFR, with semiannual payments. At the start of the first period SOFR is 4.60% (annualized). What is the net payment the company receives at the end of the first period? A) USD 60,000 B) USD 120,000 C) USD 460,000

Show the solution

The company pays fixed and receives floating.
Fixed amount = 20,000,000 × 4.00% × 0.5 = USD 400,000.
Floating amount = 20,000,000 × 4.60% × 0.5 = USD 460,000.
Net = 460,000 − 400,000 = USD 60,000, received by the company because floating exceeds fixed.
Option B uses the full-year difference instead of half a year. Option C is the gross floating amount, not the net.

Answer: A) USD 60,000.

Example 2

A bank pays floating (reference rate + 0.50%) and receives fixed at 3.20% on a EUR 50,000,000 notional with annual payments. The reference rate set at the start of the year is 2.90%. What is the net payment the bank makes? A) EUR 100,000 B) EUR 200,000 C) EUR 800,000

Show the solution

The bank pays floating and receives fixed.
Floating rate = 2.90% + 0.50% = 3.40%.
Floating amount = 50,000,000 × 3.40% = EUR 1,700,000.
Fixed amount = 50,000,000 × 3.20% = EUR 1,600,000.
Net = 1,700,000 − 1,600,000 = EUR 100,000, paid by the bank since it owes the larger floating amount.

Answer: A) EUR 100,000.

Exam tips

Circle which side pays fixed before any arithmetic. Most wrong answers come from direction errors.
Options are listed smallest to largest, so check for options that equal half or double the correct size, which signals a period-fraction trap.
If a stem says the notional is exchanged, treat it as a distractor for a plain vanilla swap.
When the stem gives a spread, add it to the floating reference rate, not to the fixed rate.
When only the net is needed, subtract the rates first, then multiply by the notional and the period fraction, working in decimals. For the first worked example: 4.60% − 4.00% = 0.60% = 0.006, so net = 20,000,000 × 0.006 × 0.5 = 60,000.

Practice questions from Pricing and Valuation of Interest Rate and Other Swaps

Interest Rate Swap Basics and Cash Flows 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 Swap Basics and Cash Flows: frequently asked questions

What is the difference between the fixed leg and the floating leg of a swap?

The fixed leg pays interest at a rate agreed at initiation that stays constant. The floating leg pays interest linked to a reference rate such as SOFR, which is reset each period. Both apply to the same notional.

Is the notional principal exchanged in an interest rate swap?

No. In a plain vanilla interest rate swap the notional is only used to compute interest. It is never paid or received. In currency swaps, notional is usually exchanged, which is a different topic.

Why is only the net payment made?

Both legs are in the same currency and fall on the same dates. Netting reduces credit exposure and cash movement, so only the difference is paid by the party owing more.

Who benefits when floating rates rise?

The fixed-rate payer benefits, because it keeps paying a fixed amount while receiving a higher floating amount. The fixed-rate receiver loses in that case.