FINC6010 Chap.5 Interest Rate and Currency Swaps
Interest Rate and Currency Swaps
Swaps exchange payment rules while original borrowing or investment remains in place. This chapter maps fixed and floating cash-flow legs, derives transformed borrowing costs, allocates comparative borrowing advantage and adds an intermediary spread. Currency swaps extend the timeline with principal exchanges and separate discount rates, making units and quote orientation central to valuation.
A floating borrower that wants fixed exposure pays fixed and receives matching floating in the swap; a fixed borrower seeking floating does the reverse. The quality-spread differential measures the total potential gain in a comparative borrowing example, and benefits allocated to both firms plus the intermediary cannot exceed it. A proposed structure is proved only by the final cash-flow ledgers for both parties.
Reference rate, reset date, day-count basis and notional must align before floating terms can be cancelled. Currency swaps add principal exchanges at inception and maturity, so each arrow needs a currency unit. Later valuation compares the present value of the two legs, using the appropriate yield curve for each currency and the current spot rate to express values in one reporting currency.
What this chapter covers
- 01
Plain-vanilla interest rate swaps
- 02
Original borrowing and transformed cost
- 03
Quality-spread differential
- 04
Intermediary compensation
- 05
Currency principal exchanges
- 06
Swap value and counterparty risk
Worked example · free
Transform floating debt into fixed
- 1Write the original floating borrowing cost.
- 1Add the fixed swap payment.
- 1Subtract the matching floating receipt.
- 1Cancel only identical benchmark terms and state the fixed result.
Key terms
- Notional principal
- The reference amount used to calculate swap payments, usually not exchanged in a single-currency rate swap.
- Quality-spread differential
- The difference between fixed-rate and floating-rate borrowing spreads in a comparative-advantage example.
- Floating leg
- The swap payment stream reset from a named reference rate under stated dates, day-count rules and a notional amount.
- Replacement value
- The current cost or benefit of replacing remaining swap cash flows at market terms after rates, currency values or credit conditions change.
- Basis swap
- A swap exchanging two different floating-rate references, leaving exposure to the spread between benchmarks rather than fixing the payment rate.
- Net settlement
- Payment of the difference between opposing obligations instead of transferring each gross amount separately. It reduces operational cash movement but does not change the contractual rates, notionals and conventions used to calculate the two legs. Gross calculations remain auditable beneath the net amount.
Interest Rate and Currency Swaps FAQ
How does a swap change a liability?
The original borrowing remains outstanding while swap receipts and payments alter its net cash-flow pattern. A floating borrower can pay fixed and receive matching floating under the swap, cancelling the benchmark component and leaving a synthetic fixed cost.
What limits the comparative-advantage gain?
The difference between the fixed borrowing spread and the floating borrowing spread sets the total potential gain in the classroom structure. Benefits assigned to both firms plus any intermediary spread cannot exceed that amount, and the proposed cash flows must reproduce each claimed final cost.
Why are currency swaps more complex?
Currency swaps commonly exchange principal at initiation and maturity as well as interest through time. Each leg uses its own currency discount rate, and the domestic value of the foreign leg changes with spot exchange rates. Units must remain attached to every cash flow.
How do I verify a proposed swap structure?
Prepare a ledger for every party containing original financing, swap payments and swap receipts. Calculate each final exposure independently, then confirm that benefits and any intermediary spread do not exceed the available quality-spread differential. Matching labels alone are not proof that cash flows cancel.
Exam move
Give each party a three-line ledger: original financing, swap payment and swap receipt. Net only after all legs are visible. In a currency swap, add a timeline for initial principal, periodic interest and maturity re-exchange, with the currency written beside every arrow. Practise transforming floating debt into fixed and fixed debt into floating until the swap direction follows from the desired final exposure.
For comparative advantage, compute fixed and floating spreads separately, subtract them and allocate the resulting ceiling among the two firms and any intermediary. Then verify the claimed saving from each full ledger. Change the benchmark on one floating leg and explain why cancellation no longer works. For currency swaps, value the legs first in their own currencies and convert only after discounting.
End each problem with a risk sentence covering counterparty replacement value, benchmark mismatch, exchange-rate movement or funding liquidity. That final sentence distinguishes a complete financial analysis from mechanical netting.
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