Strategic Financial Management · Foreign Exchange Risk Management

Currency Swaps and Interest Rate Swaps: Mechanics and Numericals

Updated 11 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 on the same currency. A currency swap exchanges principal and interest in two currencies. To solve, list each party's borrowing rates, find the net gain, split it, then trace every cash flow.

Understand Currency Swaps and Interest Rate Swaps

A swap is a contract between two parties to exchange future cash flows on agreed terms. Each party uses it to change the nature of its debt or asset without repaying the original loan. The original loan stays with the original lender. The swap sits on top of it.

In an interest rate swap (plain vanilla), 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 principal. The notional is never exchanged. Only the interest difference is usually settled. You use it to convert floating-rate debt into fixed, or the reverse.

In a currency swap, the legs are in two different currencies. The parties normally exchange principal at the start at the spot rate, pay interest to each other during the life of the swap, and re-exchange principal at maturity at the same initial rate. Because the final rate is fixed in advance, the swap removes the exchange rate risk on the borrowing.

Why would a swap save money? Because of comparative advantage. A borrower with a better credit rating usually has an edge in both fixed and floating markets, but the edge is not the same size. If the gap in fixed rates differs from the gap in floating rates, each party borrows where its relative advantage is greatest and they swap. The difference between the two gaps is the total gain, and it is shared as agreed.

The main differences: an interest rate swap involves one currency, no principal exchange and no exchange rate risk. A currency swap involves two currencies, usually exchanges principal, and hedges currency exposure as well as the interest cost. Both carry counterparty (credit) risk.

Key rules to remember

Total gain from comparative advantage: Total gain = | (Fixed-rate spread between A and B) − (Floating-rate spread between A and B) |; Spread means B's rate minus A's rate in each market. Subtract the smaller from the larger. If a bank or dealer takes a fee, deduct it before sharing.
Net borrowing cost of a party: Net cost = Interest paid to own lender + Interest paid under swap − Interest received under swap; Compare this with the cost of borrowing directly in the desired form. The difference is the saving.
Interest on a swap leg: Interest = Notional × Rate × (Days ÷ Day-count basis); For a full year it is Notional × Rate. Use the day-count the question gives (360 or 365).
Net settlement in an interest rate swap: Net payment = Notional × (Fixed rate − Floating rate) for the period; The fixed-rate payer pays this if positive and receives it if negative. Only the net amount moves.
Currency swap principal: Home-currency principal = Foreign-currency principal × Spot rate (home per foreign); The same rate is used again to re-exchange principal at maturity.

How to solve Currency Swaps and Interest Rate Swaps questions

Use this order for any swap question, whether the numbers are in one currency or two.

1Read what each party wants: fixed or floating debt, or which currency. Write it down first.
2List each party's borrowing rate in each market in a small two-by-two layout.
3Compute the spread between the two parties in each market and take the difference. That is the total gain from the swap.
4Split the gain as the question says (usually equally). Deduct any intermediary fee first.
5Decide where each party borrows: the market where its relative advantage is greatest (or its disadvantage is smallest).
6Set the target net cost for each party (direct cost minus its share of the gain) and solve for the swap payment that achieves it.
7Trace every cash flow party by party: pays to lender, pays to counterparty, receives from counterparty. For currency swaps, show the initial exchange, periodic interest and final re-exchange.
8Verify that the savings of the two parties add up to the total gain, then state the recommendation in one line.

Quickest way: Gain-first shortcut for swap numericals

When to use it: Use it for comparative advantage questions where the question asks for the saving or the swap terms, and time is short.

Compute the two spreads and subtract. That single number is the total gain, and half of it (if shared equally) is each party's saving.
Each party's target cost = its direct cost in the market it wants − its saving.
Each party borrows in the market where it does NOT want the final exposure, if that is its comparative advantage market. Then one swap payment fixes both targets.
Check: the two savings must add up to the total gain. If they do not, the swap leg is wrong.
For currency swaps, skip the theory. Write the three dates (start, each interest date, maturity) and note down the cash flows of one party. The other party's flows are the mirror image.

Common mistakes in Currency Swaps and Interest Rate Swaps

Treating the notional principal in an interest rate swap as an amount that is paid and received.
Students carry over the principal exchange from currency swaps.
Fix: In a same-currency interest rate swap, the notional is only a base for calculating interest. Show only the interest or the net interest settlement.
Finding the gain by adding the spreads or by subtracting the wrong rates.
The two spreads are in different markets, so students mix them up.
Fix: Compute B's rate minus A's rate in the fixed market and again in the floating market. Then take the difference between the two spreads.
Ignoring that floating rate is a variable (MIBOR plus a margin), so the margin is dropped from the net cost.
Students focus on the benchmark and forget the credit margin the party pays its own lender.
Fix: Always carry the margin through, for example MIBOR + 1.5%. Cancel only the MIBOR parts, never the margin.
In a currency swap, using the maturity spot rate to re-exchange principal.
Students link the swap to a forward or spot hedge.
Fix: The principal is re-exchanged at the original swap rate, so the swap fixes the rate. Use maturity spot only to show what the party would have paid without the swap.
Forgetting to deduct the intermediary's fee or sharing the gain unequally without being told.
The sharing condition is buried in the last line of the question.
Fix: Underline the sharing and fee instructions before starting. Deduct the fee from the total gain, then split the remainder as stated.
Stopping at the cash flows and not giving a conclusion.
Students treat it as a pure calculation.
Fix: End with the net cost for each party compared with its direct cost, and state the saving in percentage and rupees.

Worked examples

Example 1

Company A (rated higher) and Company B can borrow at these rates. Fixed: A 7.0%, B 9.0%. Floating: A MIBOR + 0.5%, B MIBOR + 1.5%. A wants floating-rate funds and B wants fixed-rate funds, each for ₹50 crore. They enter an interest rate swap and share the total gain equally. Show the swap and the saving of each party.

Show the solution

Fixed-market spread = 9.0% − 7.0% = 2.0%.
Floating-market spread = (MIBOR + 1.5%) − (MIBOR + 0.5%) = 1.0%.
Total gain = 2.0% − 1.0% = 1.0%. Each party gets 0.5%.
A has the greater advantage in the fixed market (2.0% against 1.0%), so A borrows fixed at 7.0%. B borrows floating at MIBOR + 1.5%.
Direct cost of what each wants: A floating = MIBOR + 0.5%, B fixed = 9.0%.
Target costs: A = MIBOR + 0.5% − 0.5% = MIBOR. B = 9.0% − 0.5% = 8.5%.
Let B pay A a fixed rate x, and A pay B MIBOR. A's net cost = 7.0% − x + MIBOR. Setting this equal to MIBOR gives x = 7.0%.
Check B: pays MIBOR + 1.5% to its lender, receives MIBOR from A, pays 7.0% to A. Net = 1.5% + 7.0% = 8.5%. This matches the target.
Annual saving on ₹50 crore: 0.5% × ₹50,00,00,000 = ₹25,00,000 for each party, ₹50,00,000 in total.

Answer: A pays B floating at MIBOR and B pays A fixed at 7.0%. A's net cost is MIBOR (saving 0.5%, ₹25 lakh a year). B's net cost is 8.5% fixed (saving 0.5%, ₹25 lakh a year). Total gain is 1.0%, equal to ₹50 lakh a year.

Example 2

An Indian company, Kaveri Ltd, needs US$10 million for 5 years. It can borrow rupees at 9% a year. A US company, Lakeview Inc, needs the rupee equivalent and can borrow dollars at 5% a year. Spot rate is ₹80 per US$. They agree a 5-year currency swap with annual interest and principal re-exchanged at the initial rate. (a) Show the cash flows of Kaveri Ltd. (b) If the spot rate at maturity is ₹86, how much would Kaveri Ltd have saved at maturity compared with buying the dollars itself?

Show the solution

Rupee principal = US$10 million × ₹80 = ₹800 million = ₹80 crore.
Start: Kaveri borrows ₹80 crore at 9% from its rupee lender and hands it to Lakeview. Lakeview borrows US$10 million at 5% from its dollar lender and hands it to Kaveri. Kaveri now has the dollars it needs.
Each year: Kaveri pays interest on the dollar loan = 5% × US$10 million = US$0.5 million, which Lakeview passes to its dollar lender. Lakeview pays interest on the rupee loan = 9% × ₹80 crore = ₹7.2 crore, which Kaveri passes to its rupee lender. Kaveri's net rupee interest is nil, and its net cost is US$0.5 million a year.
Maturity: Kaveri pays US$10 million to Lakeview and receives ₹80 crore, which it uses to repay its rupee lender. Lakeview uses the dollars to repay its dollar lender.
Effective position: Kaveri has borrowed US$10 million at 5% and has no exchange rate risk on the principal or interest.
Part (b): without the swap, Kaveri would need to buy US$10 million at ₹86 = ₹860 million = ₹86 crore at maturity. Under the swap its cost is ₹80 crore, the initial rate.
Saving at maturity = ₹86 crore − ₹80 crore = ₹6 crore.

Answer: Kaveri Ltd receives US$10 million at the start, pays US$0.5 million each year, and pays back US$10 million at maturity. The rupee interest it owes its lender is covered by Lakeview. At maturity spot of ₹86, the swap saves it ₹6 crore on principal. Annual dollar interest is the same under both routes, so the swap works as a full hedge on the principal.

Exam tips

Read the sharing condition and any bank fee in the question before you start. Marks are lost for equal sharing when the question says otherwise.
Draw a small box with the four rates and the two spreads. Examiners award marks for the gain computation even if a later step goes wrong.
Show the cash flows party by party. Net cost per party is the line the marks are attached to.
In MCQs, check the basic facts: no principal exchange in a plain interest rate swap, and currency swaps expose both parties to counterparty risk. Tricky options often swap these.
Close each numerical with a recommendation sentence and the saving in rupees. SFM answers are judged on decisions, not just arithmetic.

Practice questions from Foreign Exchange 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 a currency swap and an interest rate swap?

An interest rate swap exchanges interest payments in one currency, usually fixed against floating, on a notional that is not exchanged. A currency swap exchanges cash flows in two currencies and usually exchanges principal at the start and end. So a currency swap hedges exchange rate risk along with the interest cost.

How does a currency swap work with an example?

An Indian firm needing dollars and a US firm needing rupees each borrow in their home market and swap the principals at the spot rate. During the loan each pays the other's interest. At maturity they swap the principals back at the same rate, so neither is hurt by exchange rate movement.

How is the saving from a swap calculated?

Find each party's rate difference in the fixed market and in the floating market, then subtract the smaller difference from the larger. This is the total gain. Divide it between the parties as the question states, after deducting any intermediary fee.

Is the notional principal exchanged in an interest rate swap?

No. The notional is only used to calculate interest. In most questions only the net interest difference is settled on each date.