• Global Frameworks: CFA Level 2 (Swaps Pricing), GARP FRM Part 1.

1. Plain-Vanilla Interest Rate Swaps
An Interest Rate Swap (IRS) is an over-the-counter contract where two parties exchange periodic interest payment cash flows based on a specified Notional Principal amount for a set period.
In a classic plain-vanilla swap:
  • The Swap Buyer (Fixed-Rate Payer) pays a fixed, predetermined interest rate and receives a floating reference rate (e.g., SOFR or Euribor). This position profits if market interest rates rise.
  • The Swap Seller (Floating-Rate Payer) pays a floating reference rate and receives a fixed interest rate. This position profits if interest rates drop.

                  ┌────────────── Plain-Vanilla Swap ──────────────┐
                  ▼                                                ▼
         [Fixed-Rate Payer]  ────── Fixed Rate (e.g., 4%) ────► [Floating-Rate Payer]
                             ◄─── Floating Rate (e.g., SOFR) ───

Because both payment cash flows are denominated in the same currency, counterparties do not exchange the underlying notional principal. Instead, cash payments are netted at each settlement date to maximize operational efficiency.
2. Currency Swaps Operations
Unlike interest rate swaps, a Currency Swap involves exchanging cash flows in two different currencies.
  • Principal Exchange: The counterparties exchange the full notional principal amounts at the contract’s start using the prevailing spot exchange rate.
  • Interest Transfers: Throughout the contract’s lifespan, one party pays interest in the first currency and receives interest in the second currency. These interest payments are not netted because they use different currencies.
  • Re-exchange: At maturity, the original principal amounts are exchanged back at the exact same initial spot rate, completely eliminating exchange rate risk during the repayment step.
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