The problem a swap solves
A company has borrowed at a floating rate. Its interest cost now moves with the market, which means its profit depends on something it has no view about and no control over. It would rather pay a known amount.
It could repay the loan and borrow again at a fixed rate. That usually means early-repayment penalties, new arrangement fees, fresh negotiation and possibly a worse rate than it could have had at the outset. The loan may not even be repayable early.
A swap achieves the same economic result and leaves the loan alone. The company makes a separate agreement with a bank: it will pay the bank a fixed rate and the bank will pay it a floating rate, both on an agreed notional amount. The floating payments it receives offset the floating payments it makes on the loan, and what is left is fixed.
In words: the floating part is cancelled out by an equal and opposite floating part, leaving only the fixed leg and the loan's margin.
What is and is not exchanged
Three facts about the mechanics, and each one is examinable.
The notional principal is never exchanged. It exists only to size the interest calculations. A ₹100 crore swap does not involve ₹100 crore changing hands at any point.
Only the difference is paid. On each settlement date the two legs are netted, and one party pays the other the balance. This is why the credit exposure on a swap is small relative to its notional size.
The original loan is untouched. The company still owes its lender, still pays the contractual floating rate plus its margin, and the lender need not know the swap exists. The swap sits alongside, which is exactly why it is used in preference to refinancing.
One consequence worth drawing out: the swap hedges the reference rate, not the company's own credit. If the loan is at a benchmark rate plus 1.5% and the company's credit standing worsens so that its margin rises at the next review, the swap does nothing about that. It fixes what the market charges everybody, not what the market charges you.
Where the saving between two companies comes from
The other standard use of a swap is a pair of companies who both end up better off. It looks like something for nothing, and the explanation is the examinable part.
Suppose one company can borrow more cheaply than another in both the fixed and the floating market — it is simply the better credit. That is an absolute advantage and on its own it creates nothing. What matters is whether its advantage is bigger in one market than the other.
It usually is, and for a structural reason: fixed-rate lending commits a lender for years, so the lender's view of the borrower's credit is priced across that whole period and a weaker credit is penalised heavily. Floating-rate lending is typically repriced every few months, so less of the credit risk is locked in and the penalty is smaller. The gap between two borrowers is therefore wider in the fixed market than in the floating one.
The total available gain is the difference between the two differences:
In words: how much more the fixed market penalises the weaker borrower than the floating market does.
Each company then borrows in the market where it has the comparative advantage — which is not necessarily the one it wants to end up in — and they swap. The gain is split by negotiation, and where it falls depends on the fixed rate they agree, not on any formula.
The honest caveat, and a good answer includes it: this argument assumes the quoted rates persist. In practice a floating rate is reset repeatedly, so the apparent saving partly reflects the fact that the weaker borrower will be repriced if its credit deteriorates — a risk it keeps. Some of the "free" gain is payment for bearing that.
What a swap does not do
It does not make borrowing cheaper on average. It converts an uncertain cost into a certain one. If rates then fall, the company pays more than it would have unhedged, and that is not a failure of the hedge.
It introduces counterparty risk. The company now depends on the bank to keep paying the floating leg. That is small relative to a loan, since only net amounts are at stake, but it is not nothing.
It can be the opposite of a hedge. A company with floating-rate income and floating-rate borrowing is already matched; swapping to fixed debt would create an exposure rather than remove one. Whether a swap hedges depends on everything else on the balance sheet, which is the point a question about hedging policy is usually testing.
Where marks are lost
Exchanging the principal. Notional means notional.
Forgetting the loan's margin. The swap cancels the benchmark rate, not the spread the company pays over it. The fixed cost achieved is the swap rate plus that margin.
Getting the direction wrong. To fix a floating cost you pay fixed and receive floating. Reversing it doubles the exposure instead of removing it.
Computing the gain from the absolute advantage. The gain is the difference of the two gaps. A company better off in both markets by the same amount creates no gain at all by swapping.
Claiming a swap lowers the expected cost. It removes variance. Say that, and say what the company gives up.
Questions students ask
Why would a bank take the other side?
Because it is not taking a view. A bank runs a book of swaps in both directions, matches them off, and earns the small difference between the fixed rate it pays and the fixed rate it receives. Where it cannot match, it hedges in the futures or bond markets. The bank is selling a service, not betting on rates.
Is a swap the same as a forward rate agreement?
A forward rate agreement fixes the rate for one future period. A swap fixes it for a series of them, and can be thought of as a string of forward rate agreements priced as a single contract. The ideas are the same; a swap is the version that matches the shape of a term loan.
How is a swap valued once it has been entered into?
At the start it is worth approximately nothing to both sides, which is how the fixed rate is chosen. Afterwards it has a value: if market fixed rates have risen, the right to keep paying the old lower fixed rate is worth something, and the swap is an asset to the payer. The value is the difference between the present values of the two legs, and it is the reason a swap appears on a balance sheet at all.
A worked example
Two invented cases. Every rate and amount is made up for this example. MIBOR appears as a label for a floating benchmark; no figure here is a real market rate.
Part one: fixing a floating cost
Shringar Tools Limited has a ₹100 crore loan at MIBOR plus 1.5%. It enters a three-year swap on a ₹100 crore notional: it will pay 7% fixed and receive MIBOR.
Suppose MIBOR turns out to be 6%, then 8%, then 5%. All figures in ₹ crore:
| Year | MIBOR | Loan interest | Swap: pay fixed | Swap: receive floating | Net swap | Total cost |
|---|---|---|---|---|---|---|
| 1 | 6% | 7.50 | −7.00 | +6.00 | −1.00 | 8.50 |
| 2 | 8% | 9.50 | −7.00 | +8.00 | +1.00 | 8.50 |
| 3 | 5% | 6.50 | −7.00 | +5.00 | −2.00 | 8.50 |
Check the first row by hand: loan interest is (6 + 1.5)% of 100 = ₹7.50 crore; the swap costs 7.00 − 6.00 = ₹1.00 crore net; total 7.50 + 1.00 = ₹8.50 crore. And the third row, where MIBOR fell furthest: loan (5 + 1.5)% = ₹6.50 crore, swap 7.00 − 5.00 = ₹2.00 crore, total 6.50 + 2.00 = ₹8.50 crore.
₹8.50 crore every year, with MIBOR ranging from 5% to 8%. The algebra says why, and it is one line:
MIBOR cancels. Whatever it does, the company pays 8.5%, which is the 7% swap rate plus the 1.5% margin on its loan. Notice that the margin survives the hedge — the swap cancelled the benchmark and nothing else — and that is the detail most often dropped.
Read year 3 before moving on, because it is the one that tests whether a hedge is understood. MIBOR fell to 5%, the loan got cheaper, and the company still paid 8.5% because the swap cost it ₹2 crore. Unhedged it would have paid ₹6.50 crore. The hedge cost it ₹2 crore that year and that is not a mistake: it is the price of having paid ₹8.50 crore rather than ₹9.50 crore in year 2. Certainty is the product, and it is paid for in the years when rates go your way.
Part two: where a two-company saving comes from
Two invented companies can borrow as follows:
| Company | Fixed rate available | Floating rate available |
|---|---|---|
| Shringar (the stronger credit) | 7.00% | MIBOR + 0.30% |
| Vasant (the weaker credit) | 9.00% | MIBOR + 1.00% |
| Gap | 2.00% | 0.70% |
Shringar is cheaper in both markets, so it has an absolute advantage in both. That by itself creates nothing. What creates the gain is that the gap is wider in the fixed market than in the floating one:
Shringar wants to borrow floating; Vasant wants to borrow fixed. Both will do the opposite of what they want and then swap.
Shringar borrows fixed at 7.00%. Vasant borrows floating at MIBOR + 1.00%. They agree a swap in which Shringar pays MIBOR and receives 7.65% fixed from Vasant.
Shringar's position, adding the three pieces:
net = MIBOR + 7.00 − 7.65 = MIBOR − 0.65%
Against MIBOR + 0.30% if it had simply borrowed floating, so Shringar saves 0.30 − (−0.65) = 0.95%.
Vasant's position:
net = 1.00 + 7.65 = 8.65% fixed
Against 9.00% if it had simply borrowed fixed, so Vasant saves 9.00 − 8.65 = 0.35%.
The check that the arithmetic is right
Exactly the comparative advantage computed before either company's position was worked out. That identity is the best check in the topic: the two savings must add to the difference of the two gaps, because the swap cannot create any more than that and cannot lose any of it. If your two savings add to something else, the swap rate has been applied in the wrong direction to one of the parties.
Both companies have ended up in the market they wanted, both are better off than borrowing there directly, and MIBOR has cancelled out of Vasant's position entirely while appearing in Shringar's — which is what each of them asked for. The 7.65% is not fixed by any rule: at 7.30% Shringar would take 0.60% and Vasant 0.70%, and at 8.00% Shringar would take 1.30% and Vasant nothing at all. The split is a negotiation, and the 1.30% is the only part the arithmetic settles.
Where this fits in CB1
This page explains one idea from CB1 Business Finance. The full CB1 syllabus, with what each part is examined on, sits on the course page, and past-paper style mock exams with full solutions are where you find out whether the idea has stuck under time pressure.
Other CB1 topics explained
- Why financial reporting is regulated, and who it is regulated for
- Share capital and loan capital: why each source costs what it does
- Leasing against buying, and the only comparison that settles it
- Profit is not cash, and why a growing company can run out of money
- Return on capital employed, and the two things that drive it
- Gearing: why borrowing magnifies a shareholder return in both directions
- Modigliani-Miller: why gearing does not create value, and what does
- Dividend irrelevance, and the four reasons dividends still matter
- The cost of capital, and why a project must beat the whole pot
- NPV against IRR, and the three times IRR gives the wrong answer
- Working capital: the days between paying out and being paid
- Valuing a company: discounted cash flow against comparable multiples
- Synergies and the takeover premium: who actually gets the gain
- Company tax in an appraisal, and the relief that reverses the answer
- Hedging currency risk: the forward contract and the money-market hedge
Stuck on a term rather than the idea? The actuarial glossary defines the notation used above. If something here is wrong or unclear, tell us — these pages get corrected.