Interest Rate Swap and Currency Swap: What Actually Moves

An interest rate swap and a currency swap both exchange two schedules of payments under one agreement. The dividing line is the headline figure. In an interest rate swap it is a notional that never changes hands, and only the difference between the two sides is settled. In a currency swap it is principal in two currencies, handed over on day one and handed back on the last day.

Two streams, one agreement, in both cases. The separating question is whether the two streams are counted in the same money. When they are, the figure both streams are computed on is identical on each side, so it cancels and stays exactly where it is. When they are not, there is nothing to cancel, and each side genuinely needs the other side's money in its hands rather than a number to multiply by. Every other difference between the two arrangements falls out of that one fact about the money.

Consider something picturable without any of this vocabulary. Two neighbours share a borewell. The two neighbours agree that one of them will put in a steady Rs 4,000/- a month towards running it and the other will put in whatever the electricity bill happens to come to, and on the first of every month they work out the gap and one of them hands over the difference in cash. Nobody hands over Rs 4,000/- and receives Rs 3,650/- back a minute later. The two amounts are the same kind of money sitting in the same pockets, so the neighbours net them.

Now change one thing and watch the arrangement break. One neighbour has moved abroad and needs rupees here while the other needs that second currency there. The two neighbours cannot net anything now. There is no single pocket the difference could come out of, and no rate written into their arrangement to turn one currency into the other. Each of them simply pays what they owe, in the money they owe it in, and at the end of the year they hand back to each other the sums they each started with. The two borewell arrangements are the two swaps compared below, and what separated them was not finance at all: the separator was whether the two amounts lived in the same money.

Every figure below belongs to one invented arrangement, set out once here so it never has to be set out again. Chitrakoot Cements Limited, an invented cement maker, is the fixed payer: out goes 7.20 per cent a year, back comes the floating benchmark. Saranga Capital Limited, invented alongside it, stands opposite, sending the floating benchmark across and collecting the fixed rate. Rs 1,000 crore is the notional that each of those two rates gets multiplied by. The floating benchmark carries a plain description rather than a name. A named benchmark reads a different number on every date, and every step of the arithmetic below holds whatever it reads.

One caution governs everything after it. No exchange rate and no second currency rate stands behind this worked example, so the two arrangements are nowhere set against each other as totals. Why no honest total can be built from what exists here is worked through further down.

What is an interest rate swap, on its own?

Two parties, one agreement, one currency. One side pays a fixed rate that was negotiated and written into the document on the day it was signed. The other side pays whatever a floating benchmark happens to read at the start of each period. Both rates get multiplied by one and the same figure, and that figure carries the name notional. The notional never goes anywhere, so neither side lends anything to the other, neither side hands the notional over, and neither side ever gets it back.

Each of the two payment schedules inside the agreement is a legOne of the two payment schedules living inside a single agreement. Each side of the deal pays one of them and receives the other.. In this arrangement, Chitrakoot Cements Limited pays the fixed leg and Saranga Capital Limited pays the floating leg. Each leg is worked out the same way: take the rate, take the notional, and take the share of a year the period covers. The share of a year is the day count fractionThe number an agreement uses to turn a rate quoted for a year into the share of a year that one particular period actually covers. How it is counted is written into the document and is covered separately.. Every calculation below works one full period, so the fraction is 1.0000 throughout and never quietly does work that stays out of sight.

The notional is a multiplier and never a transfer, and that single sentence is the reason the arrangement can be enormous and still move very little money. Rs 1,000 crore is what the document leads with. In whole rupees that is Rs 10,00,00,00,000/-, and not one of those rupees moves between the two sides on any date in the arrangement. The notional is there to be multiplied by, in the way that a per-square-foot rate needs a square footage to become a rent. Nobody hands over the square footage.

Put the record's figures through it. Take Rs 1,000 crore across 7.20 per cent a year for one whole period and the fixed side arrives at Rs 72.00 crore gross. Swap in the other rate and the floating side arrives at Rs 60.00 crore gross for period one. Both amounts fall due on the same date, in the same currency, and each side is owed one of them.

Now the step that matters. Because both amounts are rupees, sitting in the same accounts, due on the same morning, one of them can simply be knocked off the other. Rs 72.00 crore owed one way against Rs 60.00 crore owed the other way leaves Rs 12.00 crore, and that difference is the only thing that travels. In whole rupees, a notional of Rs 10,00,00,00,000/- produced a single transfer of Rs 12,00,00,000/- from Chitrakoot Cements to Saranga Capital, and there the first period ends.

The second line is the algebra behind the whole comparison, and it repays a pause. The notional appears once instead of twice. Between the two rates sits a distance of 1.20 percentage pointsThe unit for the distance between two rates. Moving from 6.00 per cent to 7.20 per cent is a distance of 1.20 percentage points, and calling it 1.20 per cent would be a different claim about a different base., and Rs 1,000 crore taken across that distance for one whole period lands on Rs 12.00 crore in a single step, with neither leg ever computed on its own. The two routes agree because the notional cancels out of the subtraction. The agreement is forced arithmetic rather than a coincidence or a second opinion.

One more term of vocabulary before the other side, and then it is routed away. The floating benchmark does not float through the period. The benchmark is read once, at a moment called a resetThe moment at which a floating leg's rate for the coming period is read off and locked, after which it does not move again until the next one. When that moment falls is covered separately., and then it is fixed for that period exactly as firmly as the fixed rate is. When that reading is taken, and when the money then moves, are each covered separately and are not the subject here.

What is a currency swap, on its own?

Two parties, one agreement, and this time two currencies. At the very start each side passes across a sum in whatever currency it holds. Through the arrangement each then pays interest in the currency it received rather than the one it started with. And at the close each returns what it originally took, at a rate settled on day one. Three moments, and every one of them moves money.

Give it the same treatment the everyday example got. Two households in different countries agree to exchange their savings for a year. Each can then spend at home in the money the shops there accept. The two households swap the sums at the start. Through the year each one pays the other for having the use of that money, and pays in the currency it is sitting on. At the end of the year they hand the original sums back to each other. Nobody has been lent anything in the ordinary sense, and yet real money sat in a stranger's account for a year. Two neighbours settling a gap in cash is a completely different arrangement.

The word at the top of this document is principal rather than notional, and the whole of the difference between the two arrangements is contained in that one change of word. Principal is an amount that genuinely arrives and genuinely has to be handed back. Principal is not there to be multiplied by. Principal is there because the other side needs it. The interest each side pays during the arrangement is computed on the principal it received, so the principal does double duty: it is both a real transfer and a multiplier, where a notional was only ever the second of those.

Two consequences follow straight away, and both are the reason the rest of this guide exists. First, what each side owes during the arrangement is denominated in two different currencies. Nothing in one amount is left for the other to cancel. Second, the handing back at the close is done at an exchange rateHow much of one currency it takes to buy one unit of another at a given moment. Where such a rate is published, and what pushes it about, is covered separately outside this material. that was fixed on the first day, before anybody knew anything about what the year would do.

No figure appears anywhere for the currency arrangement. Filling one in would take a second currency, a rate priced in it and an exchange rate between the two, and not one of the three stands behind this worked example. The structure is fully teachable without them. The drawing below fills every cell in words instead of figures.

What is the one line that separates the two?

With the two documents side by side, one difference decides everything else. The deciding difference is not the number of currencies, though two currencies are what cause it. The size of the figure at the top settles nothing at all, so the deciding difference is not the size either. The deciding difference is whether the headline figure appears in the schedule of movements, and with that one line in hand any agreement can be sorted without knowing anything else about it.

The test applies at once to the arrangement already set out. Chitrakoot Cements and Saranga Capital applied two rates to Rs 1,000 crore and moved Rs 12.00 crore. Taken top to bottom, first period to last, the schedule of movements for that arrangement never shows Rs 1,000 crore once. Not at the start, not at the end, not in any period in between. Absence from the schedule is what makes the figure a notional rather than an amount, and it is a fact about the schedule rather than a fact about the number.

Read the schedule of the other arrangement and the principal is in it twice, once in each direction. The principal is the first line of the schedule and it is the last line of the schedule. Between those two lines the principal does exactly the work a notional does, sitting there being multiplied by a rate. The middle stretch is precisely why the two arrangements are confusable in the first place. The middle of the two documents looks the same. The two ends are what differ.

The size of the figure at the top settles nothing whatever about which of the two an agreement is, and so the test reads the schedule instead of the number. An arrangement with a very large figure at the top may move nothing but small differences, and an arrangement with a modest figure at the top may move every rupee of it twice. A big number feels like a big commitment, so people reason from the size of the number constantly. The reasoning is simply not available here. Rs 1,000 crore of notional and Rs 1,000 crore of principal are not the same thing and are not close to being the same thing, and the only place that difference is visible is the schedule.

What is exchanged while each one is running?

Set the two ends aside and look only at the middle, the ordinary payment dates that make up most of any arrangement's life. On the surface they behave the same way. Two amounts fall due on the same date. Each is a rate applied to a figure over a share of a year. Each side owes one of them. And then the two arrangements do something completely different with that identical situation.

In the interest rate arrangement both amounts are rupees. Both amounts are the same kind of thing, so subtracting one from the other requires nothing beyond arithmetic. Rs 72.00 crore against Rs 60.00 crore leaves Rs 12.00 crore, one side pays it, and both obligations are discharged in full by that one movement. Nobody has been short changed: paying the difference is not a partial payment, it is the agreed way of settling both amounts at once.

In the currency arrangement both amounts are also due on the same date, and there the resemblance stops. One is in one currency and one is in another. Subtracting them is not merely awkward. There is no such operation available at all: no arithmetic turns an amount in one currency into an amount in another without a rate to convert with, and the agreement supplies no rate for that purpose. The one rate the agreement does supply is the rate for the final exchange, fixed for that exchange and for nothing else. So both amounts are paid, in full, in their own currencies, and neither cancels any part of the other.

The difference is not a technicality. The difference changes what the back office does on the morning of every payment date. One arrangement generates one payment instructionThe operational message a treasury raises to move money out of one account and into another. It carries a value date, an amount, a currency and a beneficiary, and it is what actually discharges an obligation. per period, and the other generates two, in two currencies, usually through two channels and two correspondent relationships. Two instructions means two chances to miss a cut off, two sets of charges, two confirmations to match, and two ways for a date to slip. The interest rate swap looks tidier on paper and is genuinely lighter to run, and the currency swap is heavier all the way through, not just at the ends.

There is also a difference in what has to happen for the arrangement to settleTo actually discharge an obligation by moving the money, as distinct from computing what is owed. When money moves, as opposed to when it is calculated, is covered separately. cleanly. A single rupee transfer needs one account with enough in it on one morning. Two transfers in two currencies need two accounts, in two places, each funded in its own money, on the same morning, with the time zones between them working out. None of that is exotic and all of it is a place where an arrangement that was perfectly correct on paper fails to happen.

What is each side left carrying?

Both arrangements leave each side carrying things it was not carrying before, and the two lists are different lengths. Setting them out in a sentence hides that, so they belong in two columns where the reader can count them.

Under the interest rate arrangement, a side carries two things. A side carries the movement of the floating benchmark from one period to the next. The benchmark reading decides which way the difference goes and how big it is. And a side carries whether the other side is actually there on each payment date. Depending on one named organisation is what having a counterpartyThe specific named organisation standing opposite a party in a privately negotiated agreement. Each side depends on that one organisation being there on every date, rather than on a market. rather than an exchange means. Two items are the whole list.

Under the currency arrangement, a side carries three. A side carries the rate it agreed to pay on the currency it received. A side carries whether the other side is there, the same item as before but with more riding on it. And a side carries the rate between the two currencies on the day of the final exchange, an item with no equivalent anywhere in the other arrangement.

The third item is not a rate in the same sense as the others: it applies to the whole principal rather than to a difference between two legs. An interest rate arrangement puts the gap between two rates at risk. On this record the gap was 1.20 percentage points and Rs 12.00 crore over a full period. A currency arrangement puts the whole of a handed-over amount through one exchange on one future date. The two exposures are not the same size of thing, and no amount of similar vocabulary makes them the same size of thing.

Then the sentence that both columns exist to support. Neither arrangement removes anything. Each one replaces one exposure with another, deliberately, and the replacement suits the side entering it better than what it had. A borrower paying a floating rate who enters an interest rate arrangement has not stopped being exposed to rates; it now pays a fixed rate and carries whatever happens if fixed turns out to have been the expensive side. A company that needed money in a second currency and got it through a currency arrangement now has the money it wanted and carries the final exchange. Both of those may be excellent trades and neither of them is a removal. Anybody who hears removed has heard the wrong word, and the slip is worth catching. The word removed is how a sensible arrangement gets described to a board as a solved problem.

How does each arrangement end?

Endings are where most comparisons stop early, and they are where these two diverge hardest. Everything before the last date can be described in almost the same words for both. The last date cannot.

An interest rate arrangement ends by simply running out of periods. The final payment date arrives, the last difference is computed the way every other difference was computed, one side transfers it, and nothing further is owed by anybody to anybody. The last event in an interest rate arrangement is the same kind of event as every other event in it, and nobody plans for it as a separate thing. Nothing was ever handed over, so there is nothing to hand back. The document runs out and the calendar entry stops repeating.

A currency arrangement ends with an exchange of the two principal amounts, at a rate the document fixed on day one. The final exchange is the largest single movement in the entire arrangement, larger by a wide margin than any interest payment inside it, and it happens once, on a date everybody knew about from the beginning. The rate it happens at was fixed before anybody knew anything about what the intervening years would do. Fixing the rate that early is the whole reason a side entered the arrangement and the whole reason the last day carries weight the other arrangement never has.

Notice how differently the two calendars feel as a result. One tapers off. The other builds towards a single date. A treasury running the first one is doing the same small thing repeatedly until it stops. A treasury running the second one is doing the same small thing repeatedly while a very large event sits at the end of the schedule, needing both sides funded in their own money on that one morning, in an amount that dwarfs every payment before it.

What do the two have in common?

A comparison that only lists differences teaches a contrast rather than a subject, and it leaves the reader unable to explain why one word covers both of these. So here is the other half, and there is more of it than most readers expect.

Both are privately agreedNegotiated directly between two named sides rather than bought off an exchange. Everything in the document is whatever the two sides wrote into it, and nobody standing outside them guarantees it. between two named sides. Nobody bought either of these off a screen, there is no standard version of either, and every term in each document is a term two organisations negotiated with each other. Both run for a stated period against a stated calendar of dates, written into the document at the start rather than decided as they go. Both compute each leg as a rate applied to a figure over a share of a year, using a counting method the document specifies. And both leave each side depending on the other side being there, an item that turns up in every list of what somebody is carrying.

There is a fifth thing they share, and it is the subtlest one. In both arrangements the quantity actually at risk is smaller than the headline figure printed at the top, though for two completely unrelated reasons. In the interest rate arrangement it is smaller because the top figure never moves at all and only a gap between two rates ever settles. In the currency arrangement it is smaller because the principal comes back: what is at risk is the difference between an exchange agreed on the first day and whatever the world looks like on the last day, rather than the principal itself walking out of the door. The same conclusion, reached down two routes that share nothing. The similarity is worth noticing precisely because a similarity of that kind gets used to justify treating the two as one thing.

A reader who can read one of these documents can read the other, provided they check the schedule of movements before anything else. Reading one document after the other is the practical payoff of the shared rows. The vocabulary transfers. The structure transfers. The calendar transfers. The assumption about the top figure is what does not transfer, and testing it is a single check rather than a second education.

What do the two look like side by side, row for row?

The worked instance is two ledgers with identical row headings, and only one of them carries amounts. The empty column is not a drafting compromise. The empty column is the honest artefact of a comparison whose two sides are not equally knowable, and reading the two columns of the first row and the last row is the whole exercise.

Every figure in the left ledger is derivable in the open, so the left ledger comes first, in full. The notional is Rs 1,000 crore. The fixed side runs at 7.20 per cent a year. The floating benchmark came in at 6.00 per cent a year when it was read for period one. The period is one whole year, so the day count fraction is 1.0000 and does no hidden work. Multiplied out, that is Rs 72.00 crore gross on the fixed side and Rs 60.00 crore gross on the floating side. The second knocked off the first leaves Rs 12.00 crore, running from Chitrakoot Cements to Saranga Capital.

Run it the second way as a check. The two routes are worth seeing agree. Instead of computing two legs and subtracting, take the gap between the two rates directly. The gap between the two rates is 1.20 percentage points, and Rs 1,000 crore taken across 1.20 percentage points for one whole period lands on Rs 12.00 crore, in a single step. The notional is identical on both legs and drops straight out of the subtraction, so the two routes cannot disagree. Agreement of that kind is forced arithmetic rather than corroboration, and calling it corroboration would be claiming a second source where there is only one.

One last relationship makes the scale of these arrangements land, and it is worth writing down. The net of Rs 12.00 crore divided by the notional of Rs 1,000 crore is 1.2 per cent. The entire first period of a Rs 1,000 crore arrangement moved a little over one per cent of the figure at the top of it, and that ratio is the fastest correction available to anybody who reads a notional as an amount.

Now the right ledger, with the same row headings and not a single amount in any of them. What happens is fully known and how much is not, so each cell says in words what happens. At the start, an amount in one currency goes out and an amount in the other comes in. Each period, two interest amounts fall due and neither is set against the other. At the end, the two original amounts are handed back. Beneath that column sits the line that makes the emptiness legible: what would fill it in is a dated exchange rate, plus a rate for each of the two currencies, each one carrying the period it belongs to.

Why are no totals set against each other?

The obvious next move in a comparison is to total each column and say which comes to more. No such total is produced here, and the reason is worth more than the total would have been.

No total can be built from what exists here, on either side, for two separate reasons. The interest rate side has a floating benchmark reading for period one and for nothing after it. A total would need a reading for every remaining period, and this record holds none, so everything past the first would have to be made up. The currency side is emptier still: nothing there names a second currency, nothing prices one and nothing converts between the two, so a total would be made up from its very first line rather than from its second period onwards. A comparison of two totals built that way would be a comparison of two inventions wearing the clothes of a result.

The exact shape of what is missing can be set out, close enough that anybody holding the four items could supply them and finish the comparison. On the interest rate side: a dated schedule of benchmark readings, one for every remaining period, each carrying the date it was read and who published it. On the currency side: a dated exchange rate, and one rate per currency with the period it applies to written beside it. Four items. Not one of the four sits behind this worked example, none was lifted from neighbouring material, and none was filled in by working between two figures that do exist.

An invented total looks exactly like a real total, and nothing in the finished text would mark which of the two a reader had in front of them. Supplying those four items from nowhere would therefore be worse, not better. The whole argument sits in that one asymmetry. A visible gap can be closed properly, with real readings, on the day they are actually needed. A gap filled with nothing behind it becomes a figure that gets lifted into a note, lifted again into the next note, and by the time somebody thinks to ask about its source there is no source left to find.

Who actually uses this distinction, and for what?

The distinction is not a classroom sorting exercise. Four different people apply exactly this test in the course of ordinary work, and they apply it early. Almost everything downstream depends on the answer.

A lender reading a borrower's disclosures finds a figure of Rs 1,000 crore attached to an arrangement and has to decide, before anything else, whether that is money the borrower will have to find or a figure it is multiplying by. The two readings produce opposite views of the same company. The lender does not ask how big the number is. The lender reads the schedule of movements and asks whether the number appears in it. The same test runs in a credit file as on a document.

A treasury officer at the company itself is deciding how many accounts have to be funded, in which currencies, on which mornings, for the next several years. One net transfer a period is a line in a cash plan. Two full payments in two currencies a period, with a very large exchange sitting at the end, is a funding programme with a date on it. Getting that wrong is not an analytical error that shows up in a review; it is a payment that does not go out.

An analyst reading a set of accounts wants to know whether an arrangement that looks alarming in a note is alarming. A notional is not a liability and reading it as one produces a company that looks buried in obligations it does not have. A principal that has to be handed back at a rate fixed years ago is a real, dated, sized commitment and belongs in the picture. The same figure, in the same place in the same document, means two entirely different things, and the schedule of movements is the only thing in that document that settles which.

And the household version needs exactly the same skill. Somebody guaranteeing a relative's loan is in the position of the second reading: a real amount they may genuinely have to find. Somebody whose electricity bill is calculated on a sanctioned load of a certain size is in the position of the first: a figure that multiplies, that appears on every bill, and that they will never be asked to pay. Confusing the two in a personal balance sheet does exactly what confusing them does in a credit file, on a smaller stage and with the same arithmetic behind it.

Which of the two should anybody be in?

Neither is presented here as preferable to the other, and that is a position rather than a disclaimer, so it deserves a plain answer instead of a line of small print.

The two arrangements do different jobs. Which job somebody needs done depends on what they already hold and in which currency, what they already owe and in which currency, over what period, whether the money coming in arrives in the same currency as the money going out, and what it would mean for them if the other side failed to appear on the final date. Not one of those five things is known here about any particular reader, and a recommendation of one arrangement over the other would be a recommendation made to a reader never met about a position never seen.

No outcome, no realised result, no track record, no probability and no distribution of anything stands behind either arrangement. Neither one is described as attractive, cheap, safe or preferable. No basis exists on which any of those words could be attached to either.

Somebody handed either document can tell within a minute which one it is. Telling the two apart is a real skill, portable to every arrangement of this kind either of these sits next to, and it has to be true before any of the harder questions can even be asked properly.

What is covered separately?

Holding a single axis is what makes a contrast worth reading. The neighbouring subjects kept out of this one are listed below, and every item on that list gets proper treatment elsewhere.

Chitrakoot Cements Limited and Saranga Capital Limited are invented.
Educational material. Not advice on any investment, tax, budget or market position.