Swapping Interest Payments or Swapping Currencies

An interest rate swap is a contract in which two parties exchange interest payments in the same currency, usually one paying a fixed rate and the other paying a floating rate, calculated on a notional amount that is never exchanged. A currency swap is a contract in which two parties exchange principal and interest payments in two different currencies, usually swapping the principal at the start and swapping it back at the end.

Both are used to change the risk of an existing loan or investment without changing the loan itself. An interest rate swap changes exposure to interest rates, while a currency swap changes exposure to exchange rates as well.

Swaps are traded mainly between banks, companies, pension funds and asset managers, not individual investors. Advisers still need to understand them, because the funds, insurers and companies clients invest in use them every day. For the full route from the exam to a career in advice, our complete guide to how to become an investment adviser representative covers every step.

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What a Swap Is

A swap is a derivative contract in which two parties agree to exchange streams of cash flows over a set period. The payments are calculated using an agreed formula, such as a fixed rate or a floating benchmark applied to a notional amount.

Swaps are usually customised contracts agreed between the two parties, often documented under standard agreements published by the International Swaps and Derivatives Association. Many standard swaps are now cleared through central clearing houses.

The two parties are called counterparties, and each one depends on the other to make its payments. The Series 65 Exam Preparation course at FRC covers swaps alongside options, futures and the other derivatives the exam tests.

How an Interest Rate Swap Works

In a plain vanilla interest rate swap, one party pays a fixed rate and receives a floating rate, while the other pays floating and receives fixed. Both payments are calculated on the same notional amount, such as $50 million, but the notional itself never changes hands.

In practice, the two payments are netted, so only the difference is paid on each payment date. The floating rate is usually tied to a benchmark; in the United States, the Secured Overnight Financing Rate, known as SOFR, has replaced LIBOR, which stopped being published for US dollars in 2023.

A company with a floating-rate loan can pay fixed and receive floating to lock in its borrowing cost. A company with fixed-rate debt that expects rates to fall can do the opposite, paying floating and receiving fixed.

How a Currency Swap Works

In a currency swap, the two parties exchange principal amounts in two currencies at the start, usually at the current exchange rate. During the swap, each pays interest to the other in the currency it received, and at the end they exchange the principal back at the same rate used at the start.

Because the final exchange uses the original rate, a currency swap removes the exchange rate risk on the principal. The interest payments can be fixed or floating in each currency.

Companies use currency swaps to borrow where it is cheapest and convert the money into the currency they need. A US company might borrow in dollars, where it is well known, and swap into euros to fund a European factory.

Interest Rate Swap and Currency Swap Compared

Worked Example: Fixing a Floating-Rate Loan

A company has a $50 million loan paying SOFR plus 1 percentage point. It enters an interest rate swap in which it pays a fixed 4 percent and receives SOFR on $50 million.

Step one: if SOFR is 5 percent, the company pays 6 percent on its loan, receives 5 percent from the swap and pays 4 percent on the swap, a net cost of 5 percent. Step two: if SOFR falls to 3 percent, it pays 4 percent on the loan, receives 3 percent and pays 4 percent, again a net cost of 5 percent.

Step three: whatever SOFR does, the company’s borrowing cost is fixed at 5 percent, or $2.5 million a year. It has given up the benefit of falling rates in exchange for certainty.

Worked Example: Netting the Payments

Two counterparties agree a one-year swap on a $10 million notional amount, with one paying a fixed 4 percent and the other paying SOFR, which averages 4.6 percent over the year. Step one: the fixed payer owes $400,000 and the floating payer owes $460,000.

Step two: the payments are netted, so the floating payer simply pays the fixed payer the $60,000 difference. Step three: if SOFR had averaged 3.5 percent instead, the fixed payer would have paid the floating payer $50,000.

Netting is why the credit exposure on an interest rate swap is far smaller than the notional amount suggests. Neither side ever risks losing $10 million, only the net payments still due.

Study Derivatives With FRC

Derivatives questions on the exam focus on what each instrument does, who uses it and what risks it carries. Our Series 65 course explains swaps, options and futures in plain language, with examples that link each one to real client and portfolio situations.

Consider studying with FRC for every exam on your route. Explore our USA exam courses, from the SIE through the Series 7, Series 63 and Series 65.

To take advantage of the membership, explore FRC Professional Membership, which gives you a verified Digital Profile that shows employers your real-time course progress, together with the Video Resume. Current offers are on our membership deals page.

Worked Example: A Currency Swap

A US company needs €100 million for a European subsidiary and can borrow more cheaply in dollars. It borrows $110 million at 5 percent and enters a currency swap with a European bank when one euro equals $1.10.

Step one: at the start, the company gives the bank $110 million and receives €100 million. Step two: each year, the company pays the bank 3 percent interest in euros, or €3 million, and receives 5 percent in dollars, or $5.5 million, which it uses to pay its dollar lenders.

Step three: at the end, the company returns €100 million and receives $110 million back, at the original rate, whatever the exchange rate has done. The subsidiary’s euro income can cover the euro payments, so the company has matched its currency exposure.

What a Swap Is Worth After It Starts

When a swap begins, its terms are normally set so that it is worth nothing to either side. As interest rates or exchange rates move, the swap gains value for one party and loses the same value for the other.

Worked example: the company in the earlier example pays a fixed 4 percent on $50 million with five years remaining, and market swap rates rise to 5 percent. Step one: the company is paying 1 percentage point less than a new swap would require, worth about $500,000 a year. Step two: discounting five years of $500,000 at 5 percent gives a value to the company of about $2.16 million.

That value matters if the swap is ended early, because the party that has lost value must pay the other. It also explains why companies must report swap values in their financial statements and why collateral is posted as values change.

Other Types of Swaps

Interest rate and currency swaps are the most common, but there are several others. A credit default swap pays out if a named borrower defaults, working like insurance on a bond, and was at the centre of the 2008 crisis.

A total return swap pays one party the full return on an asset, such as a stock index, in exchange for a fixed or floating payment. Funds use them to gain exposure to an index without buying every security in it.

Commodity swaps exchange a fixed price for a floating market price on a commodity such as oil or natural gas, letting producers and users lock in prices. Basis swaps exchange two different floating rates, for example payments tied to two different benchmarks.

Risks in Swaps

The main risk for each party is counterparty risk, the chance that the other side fails to pay. Before the 2008 financial crisis, many swaps were traded privately with little collateral, and the near-collapse of large dealers showed how quickly that risk could spread.

Swaps also carry market risk. A company that pays fixed loses on the swap if rates fall, and one that swaps currencies can face large payments if exchange rates move sharply, even though the swap reduces its overall exposure.

Liquidity and legal risks matter too. Customised swaps can be hard to exit before maturity, and their terms must be documented carefully, which is why standard industry agreements are widely used.

How Swaps Are Regulated

After the financial crisis, the Dodd-Frank Act of 2010 created a new framework for swaps in the United States. Most swaps are regulated by the Commodity Futures Trading Commission, while security-based swaps, such as swaps on a single stock or bond, are regulated by the SEC.

Many standardised swaps must now be cleared through central counterparties, which stand between the two parties and require collateral. Many must also be traded on regulated platforms called swap execution facilities and reported to swap data repositories, so regulators can see the market’s risks.

Large swap dealers must register, hold capital and post margin. These rules have reduced counterparty risk, although they have also raised the cost of using swaps for some end users.

Why Swaps Matter to Advisers and Clients

Pension funds and insurers use interest rate swaps to match the duration of their assets to their long-term liabilities, protecting the benefits and annuity payments clients rely on. Our article on Macaulay duration vs modified duration explains the duration measures they use.

Many bond funds and some exchange-traded funds use swaps to adjust interest rate or currency exposure, or to gain exposure to an index. Advisers reviewing these funds should read how the fund uses derivatives and what risks that creates.

Floating-rate investments are also linked to the same benchmarks used in swaps. Our comparison of senior loans vs high yield bonds explains how floating-rate loans respond when benchmark rates change.

The Memory Aid

Remember “rate swap keeps one currency, currency swap crosses the border”: an interest rate swap stays in one currency, a currency swap uses two.

For principal, remember “rate swap: notional only; currency swap: principal both ways”: interest rate swaps never exchange principal, while currency swaps usually exchange it at the start and the end.

For the purpose, remember “fixed for floating to fix the cost”: a borrower with floating-rate debt pays fixed in a swap to lock in its cost.

Exam Traps to Avoid

The first trap is assuming the notional amount in an interest rate swap changes hands. It does not; it is used only to calculate the payments.

The second trap is confusing who benefits when rates rise. The party paying fixed and receiving floating gains when rates rise, because the floating payments it receives increase.

The third trap is forgetting counterparty risk. Swaps depend on both parties paying, although central clearing has reduced the risk for many standard swaps. The fourth trap is assuming swaps are regulated only by the SEC; most are regulated by the CFTC, with the SEC overseeing security-based swaps.

A Client Scenario

A client who owns a manufacturing business asks her adviser why her company’s bank is recommending an interest rate swap alongside a new $5 million floating-rate loan. She worries that the swap is a speculative product.

The adviser explains that paying fixed and receiving floating on the swap would turn the floating-rate loan into a fixed-rate cost, protecting the business if rates rise. The trade-off is that the business would not benefit if rates fell, and it would owe payments under the swap in that case.

The adviser recommends that she review the swap terms, early termination costs and counterparty with her accountant and attorney, and consider whether certainty of payments matters more to the business than potential savings. The discussion is documented, noting that the decision rests with the business and its professional advisers.

The Dictionary as a Video Library

The FRC dictionary is a study tool, not just a glossary. Every entry pairs a written explanation with deep-dive video, on-page quizzes and interactive flash cards, so you can read a concept, watch it explained and test yourself in one place.

Rules are covered in the same depth: open a rule and you will find the full explanation alongside video walk-throughs of how it applies in practice. Open the swap entry to see how swaps work and how Dodd-Frank regulates them, and test yourself with the quizzes.

Practice Questions to Test Yourself

Question one: In a plain vanilla interest rate swap, is the notional principal exchanged? No, it is used only to calculate the interest payments.

Question two: A company with a floating-rate loan wants a fixed borrowing cost. Which side of an interest rate swap should it take? Pay fixed and receive floating.

Question three: Which type of swap usually exchanges principal at the start and end? A currency swap.

Question four: On a $20 million notional, one party pays a fixed 3.5 percent and the other pays a floating rate that averages 4 percent for the year. What is the net payment? $100,000, paid by the floating payer to the fixed payer.

Question five: Which agency regulates most swaps in the United States? The Commodity Futures Trading Commission, with the SEC regulating security-based swaps.

Turn Derivatives Knowledge Into Career Evidence

Understanding how institutions use derivatives helps advisers explain the products clients hold and the risks behind them. FRC’s Digital Profile shows employers the courses you are actively studying and the progress you have earned through assessed learning, verified by FRC, and a QR code on your resume takes them straight to it.

The FRC Video Resume lets a hiring manager hear you before the interview. Explaining clearly how a swap fixes a borrower’s costs shows the breadth of knowledge that institutional and advisory teams look for.

Related Questions

Options are another common way to manage risk, and our comparison of call option vs put option explains how they differ from swaps, which create obligations for both sides rather than rights for one.

Key Points to Retain

An interest rate swap exchanges interest payments in one currency, usually fixed for floating, on a notional amount that is never exchanged, and payments are netted. A currency swap exchanges principal and interest in two currencies, usually swapping principal at the start and back at the original rate at the end, removing exchange rate risk on the principal.

Swaps carry counterparty, market, liquidity and legal risks, and after the Dodd-Frank Act most are regulated by the CFTC, with many standard swaps centrally cleared and reported. Pension funds, insurers, companies and funds use swaps to manage risk, which affects the products many clients own.

For the role the exam leads to, read our guide to what an investment advisor representative is.