FINS3616 · International Business Finance
Interest-Rate and Currency Swaps
Week 4 of UNSW FINS3616 covers interest-rate and currency swaps (Shapiro Ch 8): how counterparties exchange fixed-for-floating and cross-currency cash flows, and how a comparative advantage in borrowing markets creates a gain both parties can share. It lays out the periodic cash-flow schedule and the notional-principal exchange that distinguishes a currency swap, and shows how swaps manage long-dated interest-rate and currency exposure. The comparative-advantage swap-gain calculation is a standard examinable item for the mid-term and the cumulative final.
What this chapter covers
- 01Swap definition: an OTC agreement to exchange a series of cash flows over time
- 02Plain-vanilla interest-rate swap: exchange fixed for floating on the same notional in the same currency; principal is notional (not exchanged); only net interest settles
- 03Comparative advantage in borrowing: the quality spread differential = the gap between the two parties' credit-spread differentials, shared between them (less any dealer spread)
- 04Constructing the swap: each party borrows where its comparative advantage is largest, then swaps into the exposure it wants
- 05Currency swap: exchange principal and interest in one currency for principal and interest in another
- 06Key difference: in a currency swap principal IS exchanged — at the start (at spot) and re-exchanged at maturity (usually the original spot)
- 07Motivations: lower funding cost in a foreign currency, access to otherwise closed markets, and hedging long-dated currency exposure
- 08Valuation: a currency swap equals the difference between two bonds (one per currency), or a portfolio of forward contracts
Comparative-advantage gain from a plain-vanilla interest-rate swap
- +1Compute the two credit-spread differentials. Fixed-rate gap = 6.8% − 5.0% = 1.8%. Floating-rate gap = (SOFR + 1.0%) − (SOFR + 0.2%) = 0.8%. AAA is cheaper in both markets (absolute advantage) but its edge is larger in fixed.
- +1Total swap gain = the quality spread differential = 1.8% − 0.8% = 1.0%. Because it is positive, a swap can make both firms better off.
- +1Each borrows where its comparative advantage is greatest: AAA (bigger edge in fixed) borrows 5.0% fixed; BBB borrows SOFR + 1.0% floating. They then swap so AAA ends with floating exposure and BBB with fixed exposure — the exposures each actually wants.
- +1Split the 1.0% gain evenly (0.5% each). AAA's stand-alone floating cost was SOFR + 0.2%, so it ends near SOFR − 0.3%; BBB's stand-alone fixed cost was 6.8%, so it ends near 6.3%. Only net interest is exchanged — the principal is purely notional.
Key terms
- Swap
- An OTC agreement between two parties to exchange a series of cash flows over time — for example fixed-rate for floating-rate interest, or cash flows in one currency for cash flows in another.
- Plain-vanilla interest-rate swap
- Two parties exchange fixed-rate for floating-rate interest on the same notional principal in the same currency. The principal is notional (never exchanged); only the net interest difference is settled each period.
- Comparative advantage / quality spread differential
- The motivation for an interest-rate swap: each party borrows where it has the relative advantage (one fixed, one floating) and swaps. The gain equals the difference between the two parties' credit-spread differentials, shared between them less any swap-dealer spread.
- Currency swap
- Two parties exchange principal and interest in one currency for principal and interest in another. Unlike an interest-rate swap, the principal IS exchanged — at the start (at the spot rate) and re-exchanged at maturity (usually the original spot).
- Notional principal
- The reference amount on which swap interest is calculated. In an interest-rate swap it is never exchanged (hence 'notional'); in a currency swap the principal is genuinely exchanged at the start and end.
- Swap valuation
- A currency swap can be valued as the difference between two bonds — one in each currency — or, equivalently, as a portfolio of forward contracts. This bond/forward decomposition is how you mark a swap after rates or the spot rate move.
Interest-Rate and Currency Swaps FAQ
How is a swap gain created out of comparative advantage?
One firm has a bigger cost advantage in the fixed market and the other in the floating market (or a smaller disadvantage there). Each borrows where its relative advantage is largest, then swaps into the exposure it actually wants. The total gain to share is the quality spread differential — the difference between the two firms' credit-spread differentials — so you compute 'fixed-market gap minus floating-market gap'. If that is positive, both firms can end up paying less than they would borrowing directly; if it is zero, no swap gain exists.
What is the key difference between an interest-rate swap and a currency swap?
In a plain-vanilla interest-rate swap the two legs are in the same currency, so the principal is purely notional and is never exchanged — only the net interest difference changes hands each period. In a currency swap the legs are in different currencies, so the principal genuinely IS exchanged: once at the start at the spot rate and again at maturity (usually back at the original spot). That principal exchange is what lets a currency swap hedge long-dated currency exposure.
How do you value a currency swap after rates move?
Decompose it. A currency swap is equivalent to being long a bond in one currency and short a bond in the other, so its value is the difference between the present values of those two bonds converted at the current spot rate. Equivalently, it is a portfolio of forward contracts — one for each future exchange of cash flows — and you value it as the sum of those forwards. Both views give the same mark-to-market.
Can AI help me with swaps in FINS3616?
Yes. Sia is an AI tutor built to mirror how FINS3616 is taught and assessed at UNSW Sydney: it can walk you through a comparative-advantage swap gain, show the fixed/floating allocation, lay out a currency-swap cash-flow schedule with the initial and final principal exchange, and explain the two-bond valuation, step by step. It checks your working but does not do graded assessment, and UNSW academic-integrity rules apply — use it to be ready for the swap questions on the mid-term and final.
Exam move
The exam-critical skill here is the comparative-advantage swap gain, so drill it as a fixed procedure: compute the fixed-market gap, compute the floating-market gap, subtract to get the total gain (the quality spread differential), then allocate each party to the market where its advantage is biggest and split the gain (minus any dealer spread). Practise stating the ending all-in cost for each firm and checking it is below their stand-alone cost. Keep the one-line distinction between the two swap types front of mind — interest-rate swap: same currency, notional principal, net interest only; currency swap: two currencies, principal genuinely exchanged at start and maturity — because it is a reliable short-answer. Be able to sketch a currency-swap cash-flow schedule (initial principal exchange, periodic coupons, final re-exchange) and to explain the two-bond / portfolio-of-forwards valuation. This is Week 4 material examined in the 35% mid-term and the cumulative 40% final, so rehearse the recorded tutorial questions under time. When the allocation won't click, ask Sia to re-run it on a fresh borrower pair.
Working through Interest-Rate and Currency Swaps in FINS3616? Sia is AskSia’s AI Business and Economics tutor — ask any FINS3616 Interest-Rate and Currency Swaps question and get a clear, step-by-step explanation grounded in how FINS3616 is taught and assessed. Read this chapter free, then take your hardest questions to Sia.
