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Strategic Financial Management · Swaps

Interest Rate Swaps: Payments, Types and Numerical Problems

Updated 11 October 2026 · Fact-checked

An interest rate swap is an agreement where two parties exchange interest payments on a notional principal, usually fixed for floating. The principal is never exchanged. To solve problems, compute each party's fixed and floating amounts for the period, then pay or receive only the net difference. Then work out the effective borrowing cost.

Understand Interest Rate Swaps

An interest rate swap is a contract between two parties to exchange interest payment streams on the same notional principal for a fixed period. The notional principal is only a base for calculating interest. It is not 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 a benchmark linked rate). The other party does the opposite. A company with floating-rate debt that fears rising rates pays fixed in the swap. This turns its floating-rate loan into a fixed-rate cost.

In a basis swap, both legs are floating, but linked to different benchmarks or tenors. For example, one party pays the 3-month rate and receives the 6-month rate. It is used to remove a mismatch between the rate on assets and the rate on liabilities. A floating-to-fixed swap is the plain vanilla swap seen from the payer of fixed. A fixed-to-floating swap is the reverse view.

The swap does not change the underlying loan. Your company still pays the lender. The swap sits beside the loan, and only the net settlement moves between the swap parties. Your effective cost is the loan interest plus swap payments minus swap receipts.

Swaps are also used to share the gain from comparative advantage. If one firm has a relatively cheaper fixed-rate borrowing and the other a relatively cheaper floating-rate borrowing, each borrows where it is relatively cheaper and they swap. The total saving is the difference between the two spreads, shared as agreed.

Key rules to remember

Fixed payment per period
Fixed payment = Notional × Fixed rate × (Period in months ÷ 12)
Use the day or month fraction given in the question. Annual settlement means a factor of 1.
Floating payment per period
Floating payment = Notional × Floating rate × (Period in months ÷ 12)
Use the floating rate fixed at the start of the period (set in advance), unless the question says otherwise.
Net swap settlement
Net = Amount received − Amount paid
Only the difference is exchanged. The party owing the larger amount pays the net.
Effective cost after swap
Effective rate = Loan interest rate + Swap rate paid − Swap rate received
Express all items as a % of the same principal.
Total gain from comparative advantage
Total gain = |Difference in fixed-rate spreads − Difference in floating-rate spreads|
Share the gain as the question directs, often equally. Subtract any bank fee from the gain.

How to solve Interest Rate Swaps questions

Use the same sequence for any swap question, whether it asks for payments, effective cost or gain.

  1. 1Identify who pays fixed and who pays floating, and the notional principal.
  2. 2Note the settlement period and convert rates into period rates.
  3. 3Find the floating rate for each period from the data given.
  4. 4Compute the fixed amount and floating amount for each period.
  5. 5Find the net settlement and say clearly who pays whom.
  6. 6Add the underlying loan interest to get each party's effective cost, as a rupee amount and a %.
  7. 7Compare with the cost without the swap and state the saving or the hedge outcome.

Quickest way: Rate-difference shortcut

When to use it: Use when notional, rates and period are simple and the question asks only for net payments or effective cost.

  1. Subtract rates first: net rate = floating rate − fixed rate (for the fixed payer).
  2. Multiply the net rate by the notional and the period fraction once.
  3. If the answer is positive, the fixed payer receives. If negative, the fixed payer pays.
  4. For effective cost, use this only when the loan's floating benchmark is the same as the swap's floating leg. The floating parts then cancel, so the cost is the fixed rate plus the loan's spread. For example, a loan at MIBOR + 1% with a swap receiving MIBOR gives fixed + 1%. If the benchmarks differ, or the swap has a different tenor, do not use this shortcut. Use the full method with rupee amounts.

Common mistakes in Interest Rate Swaps

  • Treating the notional principal as an amount that is paid or received.

    Students link the word principal to loan repayment.

    Fix: State that the notional is only a base. Only interest, and only the net, is exchanged.

  • Forgetting the period fraction in semi-annual or quarterly settlements.

    Rates are quoted annually and the factor is skipped in a hurry.

    Fix: Write the fraction (6 ÷ 12 or 3 ÷ 12) next to the rate before multiplying.

  • Showing both gross payments but not the net, or naming the wrong payer.

    The direction of the swap is not written at the start.

    Fix: Label each party as fixed payer or floating payer. The net is then received minus paid for that party.

  • Ignoring the underlying loan when finding effective cost.

    Students focus only on the swap legs.

    Fix: Always add the loan interest, swap paid and swap received to reach the all-in cost.

  • Mixing up basis swap and plain vanilla swap.

    Both exchange interest on a notional.

    Fix: Plain vanilla: fixed against floating. Basis: floating against floating on different benchmarks.

  • Dropping the bank's fee or the sharing ratio in comparative advantage problems.

    The gain is found and the question is considered finished.

    Fix: Read the end of the question for fee and sharing. Deduct the fee first, then split.

Worked examples

Example 1

Aarav Textiles has a ₹10,00,000 loan at MIBOR + 1% floating. It enters a 1-year swap on a notional of ₹10,00,000, paying fixed 8% and receiving MIBOR, settled annually. At the settlement date MIBOR is 9%. Find the net swap settlement and the effective interest cost of Aarav Textiles.

Show the solution
  1. Aarav pays fixed: 10,00,000 × 8% = ₹80,000.
  2. Aarav receives floating: 10,00,000 × 9% = ₹90,000.
  3. Net swap settlement: 90,000 − 80,000 = ₹10,000 received by Aarav.
  4. Loan interest: MIBOR + 1% = 10%, so 10,00,000 × 10% = ₹1,00,000.
  5. Effective cost: 1,00,000 − 10,000 = ₹90,000, which is 9%.
  6. Check: the loan floats on MIBOR, the same benchmark as the swap's floating leg, so the shortcut applies. Fixed 8% + spread 1% = 9%. It matches.

Answer: Aarav receives a net ₹10,000. Effective interest cost is ₹90,000, or 9%, which equals the fixed 8% plus the 1% spread.

Example 2

Company P can borrow fixed at 10% or floating at MIBOR + 1%. Company Q can borrow fixed at 12% or floating at MIBOR + 1.5%. P needs floating-rate funds and Q needs fixed-rate funds. Find the total gain from a swap and each company's cost if the gain is shared equally.

Show the solution
  1. Difference in fixed rates: 12% − 10% = 2%.
  2. Difference in floating spreads: 1.5% − 1% = 0.5%.
  3. Total gain: 2% − 0.5% = 1.5%.
  4. P is cheaper in both markets, but its advantage is larger in fixed (2% against 0.5%). So P has the comparative advantage in fixed and borrows fixed at 10%. Q has the comparative advantage in floating and borrows floating at MIBOR + 1.5%. They then swap to get the type of funds each needs: P wants floating and Q wants fixed.
  5. Equal share of gain: 1.5% ÷ 2 = 0.75% each.
  6. P needs floating. Without the swap it would pay MIBOR + 1%. After the gain: MIBOR + 1% − 0.75% = MIBOR + 0.25%.
  7. Q needs fixed. Without the swap it would pay 12%. After the gain: 12% − 0.75% = 11.25%.
  8. Check: combined cost without the swap, in the markets each company needs, = (MIBOR + 1%) + 12% = MIBOR + 13%. After the swap, combined cost = MIBOR + 13% − 1.5% = MIBOR + 11.5%.
  9. This equals the actual borrowing: P at 10% fixed plus Q at MIBOR + 1.5% = MIBOR + 11.5%. It also equals the sum of the final costs: (MIBOR + 0.25%) + 11.25% = MIBOR + 11.5%. It matches.

Answer: Total gain is 1.5%. P ends up paying MIBOR + 0.25% and Q pays 11.25% fixed.

Exam tips

  • Write the direction of the swap first. Marks are lost most often on who pays and who receives.
  • Show the net settlement and the effective cost as separate lines. Examiners award marks for each.
  • In comparative advantage questions, always run the check: total cost after the swap = total cost of borrowing in the desired markets without the swap − total gain, with the gain shared as agreed.
  • If the paper gives a case scenario, expect MCQs on swap type and on whether a firm should pay fixed or floating given its view on rates.
  • Use ₹ and state the percentage cost alongside the rupee cost.

Practice questions from Swaps

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 an interest rate swap and a basis swap?

A plain vanilla interest rate swap exchanges a fixed rate for a floating rate. A basis swap exchanges one floating rate for another floating rate on a different benchmark or tenor. Both use a notional principal that is not exchanged.

How do you calculate swap payments of fixed versus floating?

Multiply the notional by the rate and by the period fraction for each leg. Then take the difference. The party with the larger amount owed pays only the net to the other party.

Who should pay fixed in a swap?

A borrower with floating-rate debt that expects rates to rise would pay fixed and receive floating. This locks its cost. If rates fall, it still pays the fixed rate and may lose out compared with staying floating.

Does the notional principal change hands in an interest rate swap?

No. Notional principal is used only to compute interest. The loan principal stays with the original lender.