New on FinoLib · Volume II: Capital Markets
I have added a new article to FinoLib, my finance education website: What Are Interest Rate Swaps? Currency Swaps Explained Too, part of Volume II: Capital Markets. This page gives you the core of the topic in expert but plain language; the full article goes much deeper.
4.5 Interest Rate Swaps
The idea in plain words
An interest rate swap is an agreement to trade interest payments: one side pays a fixed rate, the other pays a floating rate, both on the same notional amount that never actually changes hands. It is like two neighbors swapping a fixed-rate loan for a variable one without moving any principal. The swap is priced so that the fixed side and the floating side are worth the same today, which sets the par swap rate. Afterward it gains or loses value like owning, or being short, a bond.
Key points
■A pay-fixed swap at 4.09% turns the Part 2 buyout’s $330 million SOFR + 3.50% loan into a fixed 7.59%.
■Par rate = (1 − DF₃) ÷ ΣDF = (1 − 0.8864) ÷ 2.7735 = 4.09% on the illustrative curve.
■A 1-point rise makes the payer’s swap worth +$8.97 million; a 1-point fall, −$9.32 million; DV01 is about $91,400.
A closer look
An interest rate swap is an agreement between two parties to exchange interest payment streams on a notional principal amount, without ever exchanging the principal itself. The most common structure — a plain vanilla swap — has one party paying a fixed rate and receiving a floating rate (typically tied to a benchmark such as SOFR, the successor to US dollar LIBOR, whose remaining panel-based settings ended after June 30, 2023) from the other, on the same notional amount, for an agreed term.
Decision rule
Swap floating debt to fixed when a rate rise you cannot rule out would break a covenant or strain cash flow: test +200 basis points, which costs $6.6 million a year on the $330 million loan above. Match the swap’s notional, reset dates, index and maturity to the loan, and keep the notional at or below the debt you expect to have outstanding. Do not swap if you are likely to repay or refinance early, unless you price the termination value into the decision.
The costliest mistake
Letting the swap outlive the debt. Suppose rates fall 1 point and the company refinances the loan to capture the lower rate. The pay-fixed swap does not disappear with the loan: it is now worth −$9.32 million, and closing it means paying that amount, which can erase most of the saving the refinancing was meant to deliver. The same applies after an asset sale that repays debt. Put a cost-to-terminate line in every refinancing and disposal analysis, and hedge only the debt you are confident will stay outstanding.
4.6 Currency Swaps
The idea in plain words
A currency swap is two loans in different currencies traded for a while. The two sides swap principal at the start, pay each other interest in their own currencies, and swap the principal back at the original rate at the end. Pricing follows covered interest parity: the forward exchange rate equals today’s spot rate adjusted for the interest rates in the two countries, just as with FX forwards.
Key points
■On September 30, 2026, EURUSD spot 1.1355, a 4.59% dollar rate and a 3.01% euro rate give a one-year forward of 1.1530.
■A forward quoted at 1.1600 would yield $6,364 of riskless profit per $1 million.
■Since 2008 the cross-currency basis has kept market forwards slightly off textbook parity.
Decision rule
Hedge a currency exposure up to about two years with forwards, rolled if needed; hedge multi-year debt or a foreign investment with a cross-currency swap whose principal and dates match it. Size the hedge to committed cash flows and to a policy percentage of forecast ones. Before booking, recompute the forward from interest-rate parity: a quote far beyond the cross-currency basis plus the dealer’s spread signals an input error or a credit charge to question, not free money.
The costliest mistake
Refusing to hedge because the forward looks expensive. A US importer owing €10 million in a year sees the forward at 1.1530 against spot of 1.1355 and calls the 10,000,000 × (1.1529841 − 1.1355) = $174,841 gap a hedging cost. It is not a cost: it is the interest differential, which the importer would otherwise earn by keeping dollars invested at the higher US rate until payment. Leaving the payable open to avoid it is a currency bet. If the euro ends at 1.25, the unhedged bill is $12.5 million, about $970,000 more than the forward would have cost.
What the full article covers
In the full article I take you through these sections:
■4.5 Interest Rate Swaps
■4.6 Currency Swaps
It includes worked examples, a look under the hood at the mechanics, a clear decision rule, the one mistake that costs people the most, a recap, a reveal-on-click quiz and the official sources behind every figure.
Volume II: Capital Markets
Read the full article on FinoLib
The complete article, What Are Interest Rate Swaps? Currency Swaps Explained Too, with every worked example, diagram, quiz and source, is free to read in Volume II, Capital Markets on finolib.com.
Explore the Finance Education Series: Vol. II — Capital Markets · Vol. I — Global Economy · Vol. III — Finance Encyclopedia · Vol. IV — Finance Careers · Vol. V — Personal Finance