Strategic Financial Management · Interest Rate Derivatives

Interest Rate Swaps: Cash Flows and Comparative Advantage

Updated 11 October 2026 · Fact-checked

An interest rate swap is an agreement where two parties exchange interest payments on the same notional principal, usually fixed for floating. Principal is not exchanged. To solve a numerical, compute each leg's interest for the period, then settle only the net difference. Check who pays and who receives.

Understand Interest Rate Swaps

An interest rate swap is a contract between two parties to exchange interest payments on a notional principal for an agreed period. The notional is only a base for calculating interest. It is never paid or received.

The most common type is the plain vanilla swap. One party pays a fixed rate and receives a floating rate (such as MIBOR or an overnight-rate benchmark). The other party does the opposite. Both legs are in the same currency. This is the key difference from a currency swap, where two currencies are involved and principal is usually exchanged at the start and at the end.

Companies use swaps to change the nature of their debt. A firm with a floating-rate loan that fears rising rates can pay fixed in a swap and receive floating. The floating receipt offsets the loan interest, so its net cost becomes fixed. A firm with a fixed-rate loan that expects rates to fall can do the reverse.

Swaps are also used for comparative advantage. If one borrower has a relatively cheaper edge in the fixed market and another in the floating market, each borrows where it is relatively better off and then swaps. The gain is the difference between the two credit spreads. It is shared between them, often equally, and a bank intermediary may take a part.

On each settlement date only the net amount moves. The party whose leg is larger pays the difference. Other swaps include basis swaps (floating against floating on different benchmarks), amortising swaps (notional falls over time) and forward-start swaps.

Key rules to remember

Fixed leg payment: Fixed payment = Notional × Fixed rate × (Days ÷ 365), or × (1 ÷ payments per year); Use the day-count in the question. If none is given, use the period fraction such as 6/12 for half-yearly.
Floating leg payment: Floating payment = Notional × Floating rate set at start of period × period fraction; The rate is fixed at the beginning of the period and paid at its end.
Net settlement: Net = Fixed leg − Floating leg; If positive, the fixed payer pays the net. If negative, the fixed payer receives it.
Comparative advantage gain: Total gain = |Fixed spread difference − Floating spread difference|; Spread difference = rate of the weaker borrower minus rate of the stronger borrower in each market.
Net cost after swap: Net cost = Interest paid on own borrowing + Swap payment − Swap receipt; Compute it separately for each party and compare with the direct borrowing cost.
Swap value at a date: Value (to fixed payer) = Value of floating-rate bond − Value of fixed-rate bond = Par − PV of fixed-rate bond (immediately after a reset date); The floating-rate bond, including the notional, is worth par immediately after a reset date, once the coupon due on that date has been paid. Value the fixed-rate bond on its remaining coupons and notional, discounted at current market rates. Between reset dates, the floating leg is not exactly par.

How to solve Interest Rate Swaps questions

Use this order for any swap question, whether it asks for cash flows, net cost or gain.

1Identify the notional, tenor, settlement frequency and who pays fixed and who pays floating.
2Write the period fraction (for example 6/12 for half-yearly settlement).
3Compute the fixed leg for one period.
4Compute the floating leg using the rate applicable to that period, as given or forecast.
5Find the net settlement and state who pays whom.
6Add the swap flows to each party's own borrowing interest to get the net cost.
7For comparative advantage, find both spread differences, compute the total gain, split it as the question says, and set the swap rates to deliver those savings.
8Compare the final cost with direct borrowing and write a clear conclusion.

Quickest way: Net-cost shortcut with a table

When to use it: Use this when the question gives loan rates and swap terms and asks for the effective cost to each party.

Draw two columns, one per party, and list its loan interest, swap payment and swap receipt.
Put payments as negatives and receipts as positives, and add them.
Convert the net to a percentage of the notional.
Compare it with the direct rate; the difference is the saving.
Check that total savings of both parties equal the computed gain (minus any bank fee).

Common mistakes in Interest Rate Swaps

Exchanging the full notional principal in a plain vanilla swap.
Students mix it up with a currency swap.
Fix: State that notional is never exchanged in an interest rate swap. Only the net interest moves.
Using the annual rate for a half-yearly or quarterly period.
The period fraction is forgotten under time pressure.
Fix: Write the period fraction beside each leg before multiplying.
Using the floating rate at the end of the period for that period's payment.
Students assume the rate is set when paid.
Fix: Unless the question says otherwise, the floating rate is set at the start of the period and paid at its end.
Getting the direction of the net payment wrong.
Fixed payer and floating payer roles get swapped.
Fix: Label each party as fixed payer or floating payer first. The fixed payer pays Net = Fixed − Floating if it is positive.
Taking the gain as one spread rather than the difference of spreads.
Students compare rates in only one market.
Fix: Compute the spread gap in the fixed market and in the floating market. The gain is the difference between those gaps.
Ignoring the bank's fee when splitting the gain.
The intermediary is read as only a link.
Fix: Deduct the bank's share from the total gain first, then split the rest as instructed.

Worked examples

Example 1

Firm A has a ₹10,00,00,000 swap for 2 years with half-yearly settlement. A pays fixed at 8% p.a. and receives floating. The floating rate set for the first six months is 7% p.a. and for the second six months is 9% p.a. Find the net payment in each of the first two periods.

Show the solution

Period fraction = 6/12 = 0.5.
Fixed leg each period = ₹10,00,00,000 × 8% × 0.5 = ₹40,00,000.
Period 1 floating = ₹10,00,00,000 × 7% × 0.5 = ₹35,00,000.
Period 1 net = 40,00,000 − 35,00,000 = ₹5,00,000, paid by A as fixed payer.
Period 2 floating = ₹10,00,00,000 × 9% × 0.5 = ₹45,00,000.
Period 2 net = 40,00,000 − 45,00,000 = −₹5,00,000, so A receives ₹5,00,000.

Answer: Period 1: A pays a net ₹5,00,000. Period 2: A receives a net ₹5,00,000.

Example 2

Company X (lower rated) can borrow fixed at 12% or floating at MIBOR + 1.5%. Company Y (higher rated) can borrow fixed at 10% or floating at MIBOR + 0.5%. X wants fixed-rate funds and Y wants floating-rate funds. They swap directly and share the total gain equally. Find each party's net cost.

Show the solution

Fixed spread difference = 12% − 10% = 2%.
Floating spread difference = 1.5% − 0.5% = 1%.
Total gain = 2% − 1% = 1%. Each gets 0.5%.
Y has the relative advantage in fixed, X in floating. So Y borrows fixed at 10% and X borrows floating at MIBOR + 1.5%.
X wants fixed. Its target is 12% − 0.5% = 11.5%. Y wants floating. Its target is MIBOR + 0.5% − 0.5% = MIBOR.
Set the swap: X pays Y a fixed 11.5% and Y pays X MIBOR + 1.5%.
X net cost = (MIBOR + 1.5%) + 11.5% − (MIBOR + 1.5%) = 11.5%.
Y net cost = 10% + (MIBOR + 1.5%) − 11.5% = MIBOR.
Check the savings. X: 12% − 11.5% = 0.5%. Y: (MIBOR + 0.5%) − MIBOR = 0.5%. Together they equal the 1% total gain.

Answer: X pays 11.5% fixed effectively (saving 0.5%). Y pays MIBOR effectively (saving 0.5%). Total gain is 1%, shared equally.

Exam tips

Write the fixed and floating payer for each party before any calculation; most lost marks come from direction errors.
State the assumption on day count and rate-setting date in one line when the question is silent.
In comparative advantage questions, show both spread differences and the total gain explicitly. Examiners award marks for this step.
Verify your answer by checking that each party's saving adds up to the total gain (net of any bank fee).
For the MCQ section, be ready to distinguish an interest rate swap from a currency swap: same currency and no principal exchange versus two currencies with principal exchange.

Practice questions from Interest Rate Derivatives

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 currency swap and an interest rate swap?

An interest rate swap exchanges interest payments in the same currency on a notional principal that is never exchanged. A currency swap involves two currencies and usually exchanges principal at the start and end, along with interest payments.

How do I calculate swap cash flows for fixed vs floating?

Compute the fixed leg as notional × fixed rate × period fraction. Compute the floating leg the same way using the floating rate for that period. Only the net difference is paid by one party to the other.

What is comparative advantage in an interest rate swap?

It arises when the credit spread between two borrowers differs between the fixed and floating markets. Each borrows where it is relatively cheaper and then swaps. The total gain is the difference between the two spreads.

Does the notional amount change hands in a swap?

No. In a plain vanilla interest rate swap, the notional is only used to compute interest. Settlement is on the net interest amount.