Module 15 • Swaps

Long-Term Debt Financing: Plain Vanilla, Interest Rate, and Currency Swaps

A swap is a multi-period agreement to exchange cash flows. In this module, the core focus is on plain vanilla interest rate swaps, broader interest rate swaps, and currency swaps. The big picture is simple: firms use swaps to reshape their debt so that their financing better matches their operating cash flows, risk exposure, and comparative borrowing advantage.

Plain Vanilla Swap Interest Rate Swap Currency Swap Comparative Advantage Embedded Video
Theme

What a swap changes

Debt profile
Fixed ↔ floating, domestic ↔ foreign currency, or both.

Why firms use swaps

Match cash flows
Revenue currency and interest exposure should align with operations.

Finance idea

Comparative advantage
Borrow where cheaper first, then swap into the desired exposure.
Core Concept

What is a swap?

Swap: a contract in which two parties agree to exchange a series of future cash flows. Unlike a forward contract, which usually has one settlement date, a swap has many settlement dates.

How these swap terms are related

Term What it really means Typical cash-flow pattern Main classroom idea
Interest rate swap A broad category of swaps that exchange interest-payment structures, usually in the same currency. Can include fixed-for-floating or other interest-rate payment structures. Used to manage interest-rate exposure.
Plain vanilla interest rate swap The simplest and most common type of interest rate swap. One side pays fixed, and the other side pays floating, usually in the same currency. This is the standard version normally taught first in finance classes.
Currency swap A different type of swap involving different currencies, often with interest payments and sometimes principal exchange. For example, one side may pay USD cash flows while the other pays EUR or NOK cash flows. Used to manage currency exposure and better match financing to foreign-currency cash flows.
Easy takeaway: A plain vanilla swap is not separate from an interest rate swap. It is the basic fixed-for-floating version of an interest rate swap.
Plain Vanilla Swap

Plain vanilla interest rate swap

The plain vanilla swap is the standard fixed-for-floating interest rate swap. It is called “plain vanilla” because it is the most basic, most common form.

Structure

  • One party pays fixed and receives floating.
  • The other party pays floating and receives fixed.
  • The notional principal is usually not exchanged in a plain vanilla interest rate swap.
  • The swap changes the interest-rate exposure, not the original principal borrowed.
Example intuition: a firm that issued fixed-rate debt but now prefers floating-rate exposure can enter a swap to receive fixed and pay floating. The fixed-rate receipt offsets its debt cost.

Plain vanilla swap cash-flow view

Company A pays fixed ↔ receives floating
Company B receives fixed ↔ pays floating
Why “plain vanilla” matters
It is the foundation for understanding more complex swap structures. Once you understand the plain vanilla version, the larger family of swaps becomes much easier to learn.
Plain Vanilla Interest Rate Swap

Plain vanilla interest rate swap: comparative advantage example

This is a plain vanilla interest rate swap example. It is called plain vanilla because it is the basic fixed-for-floating swap in the same currency. This example also shows comparative advantage: firms may borrow where they are relatively stronger first, then use the swap to get the type of debt they actually want.

Big idea: borrow first where you are relatively stronger, then use the swap to transform the loan into the type of debt you actually want.

Step 1: Compare direct borrowing costs

Company Fixed-rate borrowing Floating-rate borrowing What stands out?
A 10.0% 6M LIBOR + 0.30% A is much better than B in both markets, but the gap is bigger in fixed.
B 11.2% 6M LIBOR + 1.00% B is worse in both markets, but is less worse in floating.

Step 2: Measure the comparative advantage

Fixed-rate gap
11.2% − 10.0% = 1.20%
Floating-rate gap
1.00% − 0.30% = 0.70%
Extra gain from swapping
1.20% − 0.70% = 0.50%
Interpretation: A has a bigger relative advantage in the fixed-rate market. So A should borrow fixed. B is relatively better in the floating-rate market, so B should borrow floating. Then they swap.

Step 3: Show what each company wants, does, and gets after the swap

Company A

A wants floating-rate debt
If A borrows directly
LIBOR + 0.30%
This is what A would pay if it went straight to the floating-rate market.
Better route
Borrow fixed at 10.0%
A borrows where it has the strongest relative advantage.
After the swap
LIBOR + 0.05%
If the 0.50% total gain is split equally, A saves 0.25%.
Direct floating cost = LIBOR + 0.30% Swap result = LIBOR + 0.05% Savings = 0.25%

Company B

B wants fixed-rate debt
If B borrows directly
11.20%
This is what B would pay if it went straight to the fixed-rate market.
Better route
Borrow floating at LIBOR + 1.00%
B borrows where its relative disadvantage is smaller.
After the swap
10.95%
If the 0.50% total gain is split equally, B also saves 0.25%.
Direct fixed cost = 11.20% Swap result = 10.95% Savings = 0.25%

In class exercise: how the swap actually happens

Counterparty A
Borrows fixed first
Counterparty B
Borrows floating first
Floating
A wants floating
Fixed
B wants fixed
A pays LIBOR + 0.55% to B
B pays fixed 10.5% to A
A pays bank 10.0%
B pays bank LIBOR + 1.0%
Read the picture in three layers: (1) A borrows from the bank, (2) B borrows from the bank, (3) A and B swap cash flows with each other. After netting, A ends up with floating-rate debt and B ends up with fixed-rate debt.

Company A: why the swap helps

Step 1 — Original borrowing A borrows at a fixed rate and pays the bank 10.0%.
Step 2 — What A receives in the swap A receives fixed 10.5% from B.
Step 3 — What A pays in the swap A pays LIBOR + 0.55% to B.
Net for A: 10.0% − 10.5% + (LIBOR + 0.55%) = LIBOR + 0.05%

So A has changed its original fixed-rate debt into floating-rate debt.

Company B: why the swap helps

Step 1 — Original borrowing B borrows at a floating rate and pays the bank LIBOR + 1.0%.
Step 2 — What B receives in the swap B receives LIBOR + 0.55% from A.
Step 3 — What B pays in the swap B pays fixed 10.5% to A.
Net for B: (LIBOR + 1.0%) − (LIBOR + 0.55%) + 10.5% = 10.95%

So B has changed its original floating-rate debt into fixed-rate debt.

Teaching takeaway: The swap does not erase the original loan. Each firm still keeps its original bank borrowing. The swap is an extra layer of cash flows added on top. The key is to write every payment and receipt clearly, then net them.

In this diagram, A and B first borrow where they have the comparative advantage. Then they exchange cash flows through the swap. A wants floating-rate exposure, so it borrows fixed first and then swaps into floating. B wants fixed-rate exposure, so it borrows floating first and then swaps into fixed. The gain comes from borrowing in the relatively better market first, then using the swap to transform the debt type.

Why this is better than direct borrowing
  • A wants floating, but it should not borrow floating directly because its biggest advantage is in fixed.
  • B wants fixed, but it should not borrow fixed directly because it is relatively less disadvantaged in floating.
  • By borrowing in the better market first and then swapping, both firms can do better than borrowing directly in the market they ultimately want.
Here, the total gain of 0.50% is split equally: 0.25% goes to A and 0.25% goes to B. In real life, part of the gain may also go to a swap dealer or bank.
Currency Swap

Currency swap: changing both currency and interest structure

What makes a currency swap different?

  • Cash flows are exchanged in different currencies.
  • Unlike a plain vanilla interest rate swap, the principal may also be exchanged at the beginning and the end.
  • Used when a firm wants debt service in the same currency as its revenues or operating costs.
A U.S. firm with euro revenues may want euro debt payments. A European firm with U.S. dollar revenues may want dollar debt payments. A currency swap can help each side achieve that.

Example structure

SalmonCo (Norway) pays floating NOK ↔ receives fixed USD
SeaFoods (USA) pays fixed USD ↔ receives floating NOK
Party Pays in swap Receives in swap
SalmonCo Floating NOK Fixed USD
SeaFoods Fixed USD Floating NOK
When to think “currency swap” immediately
If the problem talks about matching financing to foreign-currency revenue, changing the currency of future debt service, or exchanging both interest and principal in different currencies, you should think of a currency swap.
Embedded Video

Videos that play directly on the page

These videos play directly on the page. The first explains the basics, the second explains interest rate swaps more directly, and the third shows a real-world Greece case.

How swaps work — basics

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Interest Rate Swap Explained

Embedded from YouTube

How Goldman Sachs Helped Mask Greece's Debt

Embedded from YouTube
Classroom takeaway: swaps can be useful financing tools, but they can also be used to change how debt looks. That does not make the debt disappear.
Real-World Case

Goldman Sachs and Greece: simple explanation

This case is a good reminder that derivatives can change the appearance and timing of cash flows, but they do not erase the underlying debt.

What happened?

Greece had a large debt problem. Goldman Sachs helped structure derivative deals that made part of the debt look less visible in the official numbers at the time.
  • The deal helped Greece make its finances look better than they really were.
  • This did not mean the debt disappeared.
  • It mostly changed how the debt was reported and when some costs showed up.

Why did Greece do this?

  • To make the government’s financial position look stronger.
  • To reduce pressure from European budget rules.
  • To buy time instead of fixing the deeper debt problem right away.
Big lesson: debt is still debt. A complicated transaction may hide part of the problem for a while, but eventually the cash still has to be paid.

Why did this become a crisis later?

1. Too much debt

Greece already had a weak debt position. The swap did not solve that core problem.

2. Confidence fell

Once investors worried about repayment, borrowing became harder and more expensive.

3. The economy weakened

A weaker economy means lower tax revenue and more stress on the government budget.

Easy takeaway:
Goldman helped Greece change how some debt looked in the short run.
But the country still owed the money.
When the true weakness became clear, Greece faced a major debt crisis anyway.
Very short class summary
Swaps can be useful tools for risk management. But they can also be used in ways that make finances look healthier than they really are. That may delay the problem, not solve it.
How to Solve

How to solve swap questions clearly

Step 1

Write the company’s original bank borrowing cost.

Step 2

Write the swap cash flows separately: what the company pays, and what it receives.

Step 3

Net the cash flows carefully. Cancel what offsets.

Step 4

Compare the effective result to direct borrowing without the swap.

In most exam or homework settings, the real skill is netting. Treat the swap as one more layer of cash flows on top of the original bank borrowing.
In-Class Example

Visual netting: how the swap changes each firm's borrowing cost

Given structure

Show the exact netting logic

Company A: fixed debt → floating debt

A first borrows at a fixed rate, then uses the swap to end up with floating-rate exposure.

Bank loan Pay 10.0%
Swap receipt Receive 10.5%
Swap payment Pay LIBOR + 0.55%
10.0% − 10.5% + LIBOR + 0.55% = LIBOR + 0.05%
Meaning: the fixed pieces almost cancel, so A effectively ends up with LIBOR + 0.05%. A has been transformed from fixed-rate borrowing into floating-rate borrowing.

Company B: floating debt → fixed debt

B first borrows at a floating rate, then uses the swap to end up with fixed-rate exposure.

Bank loan Pay LIBOR + 1.0%
Swap receipt Receive LIBOR + 0.55%
Swap payment Pay 10.5%
(LIBOR + 1.0%) − (LIBOR + 0.55%) + 10.5% = 10.95%
Meaning: the LIBOR terms cancel except for the spread difference, so B effectively ends up paying 10.95%. B has been transformed from floating-rate borrowing into fixed-rate borrowing.

Quick checker

Output will appear here.
Quiz

Practice quizzes for Module 15

Use these quizzes to check your understanding of plain vanilla swaps and the Greece / Goldman Sachs case.

Quiz 1 — Plain Vanilla Interest Rate Swap

Review the basic structure of a plain vanilla interest rate swap, fixed vs. floating, same-currency logic, and why firms may use this type of swap.

Open Quiz 1

Quiz 2 — Greece, Goldman Sachs, and Currency Swap

Review the Greece case, cross-currency swaps, how the debt was masked, and why the debt problem still remained.

Open Quiz 2

These quizzes are short self-checks for review before homework and the final.
Homework

Homework of Module 15

Due with the final · Optional

This homework reviews two major ideas from this module: currency swaps and plain vanilla interest rate swaps. For Question 3, the key is to write down each party’s cash flows clearly and then net them.
Question 1 — Goldman Sachs and Greece

How did Goldman Sachs help Greece cover its debt by using a currency swap?

Hint: Goldman Sachs helped the Greek government mask the true extent of its deficit through a derivatives deal. In effect, Goldman Sachs arranged a secret loan for Greece disguised as an off-the-books cross-currency swap — a complicated transaction in which Greece’s foreign-currency debt was converted into a domestic-currency obligation using a fictitious market exchange rate. This helped Greece legally circumvent the EU Maastricht deficit rules for a period of time.

However, the debt did not disappear. When the swap matured, the debt burden was still real and still had to be paid.

Reading reference: Goldman’s Greek Gambit

Question 2 — Explain a plain vanilla interest rate swap using an example

Explain what a plain vanilla interest rate swap is by using an example.

In your answer, explain that a plain vanilla interest rate swap is a contract in which two parties exchange interest-payment obligations over time in the same currency. In the most common form, one party pays a fixed rate and the other pays a floating rate.

You may use a simple example such as this:

  • Firm A has fixed-rate debt but wants floating-rate exposure.
  • Firm B has floating-rate debt but wants fixed-rate exposure.
  • They enter into a swap so that Firm A pays floating and receives fixed, while Firm B pays fixed and receives floating.

Explain how this swap helps each firm better match the type of debt it wants.

Reminder: this is an interest rate swap, not a currency swap, because the example stays in the same currency and only changes fixed vs. floating.
Question 3 — Value of the swap to AAA, BBB, and the swap bank

Company AAA will borrow $1,000,000 for ten years and prefers a floating-rate loan. Company BBB will borrow $1,000,000 for ten years and prefers a fixed-rate loan.

Company Fixed-rate borrowing cost Floating-rate borrowing cost
AAA 10.0% SOFR
BBB 12.0% SOFR + 1.5%

Notes

  • Company AAA expects interest rates to fall in the future and therefore prefers a floating-rate loan. However, AAA can get a better direct deal in the fixed-rate market.
  • Company BBB expects interest rates to rise and therefore prefers a fixed-rate loan. However, BBB’s comparative advantage is in getting a floating-rate loan.
  • Therefore, both companies may be better off with a plain vanilla interest rate swap.

Assume a swap bank helps the two parties

  1. Firm BBB will pay the swap bank, on $1,000,000, at a fixed rate of 10.30%.
  2. The swap bank will pay firm BBB, on $1,000,000, at the floating rate of SOFR − 0.15%.
  3. Firm AAA will pay the swap bank, on $1,000,000, at the floating rate of SOFR − 0.15%.
  4. The swap bank will pay firm AAA, on $1,000,000, at a fixed rate of 9.90%.

Please answer the following questions

  • Show the value of this swap to firm AAA. (Answer: Firm AAA can save $500 each year.)
  • Show the value of this swap to firm BBB. (Answer: Firm BBB can save $500 each year.)
  • Show the value of the swap to the swap bank. (Answer: The swap bank can earn $4,000 each year.)
Hint: how to net the cash flows

Just write down all relevant transactions for each player and then sum them up.

Firm AAA:
AAA borrows directly from the bank at 10.0%.
AAA also pays the swap bank SOFR − 0.15%.
AAA receives 9.90% from the swap bank.
Therefore:

AAA net cost = 10.0% − 9.90% + (SOFR − 0.15%) = SOFR − 0.05%

Since AAA could borrow directly at SOFR, AAA saves 0.05% per year. On $1,000,000, that is:

AAA savings = 0.0005 × 1,000,000 = $500 per year

Firm BBB:
BBB borrows directly from the bank at SOFR + 1.5%.
BBB receives SOFR − 0.15% from the swap bank.
BBB pays 10.30% to the swap bank.
Therefore:

BBB net cost = (SOFR + 1.5%) − (SOFR − 0.15%) + 10.30% = 11.95%

Since BBB could borrow directly at 12.0%, BBB saves 0.05% per year. On $1,000,000, that is:

BBB savings = 0.0005 × 1,000,000 = $500 per year

Swap bank:
The swap bank receives 10.30% from BBB and pays 9.90% to AAA.
It also receives SOFR − 0.15% from AAA and pays SOFR − 0.15% to BBB.
The floating-rate payments cancel out. Therefore:

Swap bank net profit = 10.30% − 9.90% = 0.40%

On $1,000,000, that equals:

Swap bank profit = 0.0040 × 1,000,000 = $4,000 per year
Reminder: in Question 3, do not jump straight to the answer. First write the bank borrowing, then the swap payments, and then net them carefully.