Types of Swaps – Interest Rate vs Currency Swaps

1. Introduction

While there are many complex swaps (Equity Swaps, Volatility Swaps), for exam purposes, the two most important types are Interest Rate Swaps (IRS) and Currency Swaps.

2. Interest Rate Swap (IRS)

• Definition: An agreement to exchange interest payments in the same currency.
• Common Structure (Plain Vanilla): One party pays a Fixed Rate, and the other pays a Floating Rate (e.g., LIBOR or SOFR).
• Notional Principal: The principal amount (e.g., $10m) is NOT exchanged. It is just used to calculate interest.

3. Currency Swap

• Definition: An agreement to exchange principal and interest payments in different currencies.
• Structure:
  1. Start: Exchange Principal (e.g., $10m for ₹800m).
  2. During: Exchange Interest payments (one pays $, one pays ₹).
  3. End: Re-exchange Principal (₹800m for $10m).
• Purpose: To hedge against long-term exchange rate risk.

4. Comparison Table

5. Exam Notes: Writing the Answer

Question: "Distinguish between Interest Rate Swap and Currency Swap." (5 Marks)

Answering Structure:

1. Currency: IRS = Single Currency. Currency Swap = Two Currencies.
2. Principal: Emphasize that "Principal is exchanged ONLY in Currency Swaps".
3. Risk: IRS covers Interest Risk. Currency Swap covers Forex Risk.

6. Quiz Time! 🎯