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A swap is

an agreement between two parties
to exchange cashflows in the future.

The agreement defines
the dates when the cashflows are to be paid and
the way that they are to be calculated.

Usually, the calculation of the cashflows involves
the future values of
one or more market variables
interest rates,
security prices,
commodity prices or


In a “plain vanilla” interest rate swap (also known as a “par swap”)

Company B agrees to pay Company A
equal to interest at a
predetermined fixed rate
on a notional principal
for a number of years.

At the same time,
Company A agrees to pay Company B
cashflows equal to interest at a
floating rate
on the same notional principal
for the same period of time.

The currencies of the two sets of cashflows
are the same.


For swaps note that

1  The notional principal
⁃ is used only for the calculation of interest payments.
⁃ The principal itself is not exchanged. 

2  The floating-rate payment to be paid at a particular date is
⁃ usually based on the value of the relevant floating rate
⁃ at the previous cashflow payment date.
⁃ This means that at
⁃ any time
⁃ the monetary amount of the next floating payment
⁃ is always known.
⁃ In many interest rate swaps, the floating rate is LIBOR. 

3   The phrase plain vanilla is used here because we are referring to the most basic form of interest rate swap.
⁃ Other more complicated swaps are often referred to as
⁃ exotic swaps. 


What is LIBOR?

LIBOR is short for the London Interbank Offered Rate.
a LIBOR rate is the short-term spot interest rate
at which one large international bank
is willing to lend money to another large international bank.
specifically, LIBOR rates are
the rates of interest offered between
Eurocurrency banks
for fixed-term deposits.


A series of LIBOR rates exists for different terms

(from overnight lending up to 12 months)
in many of the major currencies.
These include the
US dollars,
UK sterling,
Japanese yen,
Swiss francs,
Australian dollars and
New Zealand dollars.


LIBOR zero rates are generally

higher than the corresponding Treasury Bill rates.
This is because they are not risk-free,
as banks are able to default on their loans.


The floating-rate payments under many interest rate derivatives are based on

LIBOR rates.


cashflows under a “plain vanilla” swap.

5-year interest rate swap
based on a notional principal of $50 million.
Under the terms of the swap,
Company B agrees to make interest payments annually in arrears
based on a fixed interest rate of 6% pa,
in return for which Company A makes
corresponding variable interest rate payments
based on the 1-year (spot) LIBOR rate.
The cashflows paid can be represented in a diagram.


Using a swap to transform the nature of the liabilities

The swap contract has the effect of
transforming the nature of the liabilities.
In the example above, Company B
can use the swap
to transform a
floating-rate loan into a fixed-rate loan,
while, for Company A,
the swap has the effect of
transforming a fixed-rate loan into
a floating-rate loan.


swaps can be used to transform the nature of an asset

from one earning
a fixed rate of interest into one
earning a floating rate of interest
(or vice versa).


Arranging a swap

Usually, two non-financial companies
do not get in touch directly to arrange a swap.
They each deal with a financial intermediary
(such as a bank)
which is remunerated
by the difference
between the value of
a pair of offsetting transactions,
providing neither client defaults on their swap.


Interest rate swap with a bank as intermediary example

  A is a net borrower at a floating rate of LIBOR + 0.35% pa, ie 0.1% pa more than before 

  B is a net borrower at a fixed rate of 6.6% pa, ie 0.1% pa more than before 

  providing neither A nor B defaults on their swap, the bank as intermediary will end up making a profit of 0.2% pa on the principal of $50 million, ie $100,000 pa for the 5-year life of the swap.


In practice, any outstanding risk to the intermediary is

normally collateralised
with securities,
minimising the default risk – t
hese securities are deposited with the intermediary and
retained in the event of default by the counterparty.


warehousing swaps:

In practice, it is unlikely that two companies
will contact an intermediary
at the same time and want
to take opposite positions
in exactly the same swap.
For this reason, a large financial institution will be prepared to
enter into a swap
without having an offsetting swap
with another counterparty in place.


Problems with warehousing swaps

bank should assess carefully
the risks it is taking on and
may decide to hedge them,
for example using appropriate forwards and futures.


Valuing an interest rate swap

1. If we assume no possibility of default
(which is reasonable when collateralised),
an interest rate swap can be valued
as a long position in one bond
compared to a short position in another bond,
since the notional principal is the same in both cases.

2. Alternatively, it can be valued
as a portfolio of forward rate agreements.


Variations on the vanilla interest rate swap include:

1  zero coupon swaps
⁃ (where each individual payment
⁃ under the par swap
⁃ is traded separately) 

2  amortising swaps
⁃ (where the principal
⁃ reduces in a predetermined way) 

3  step-up swaps
⁃ (where the principal increases
⁃ in a predetermined way) 

4  deferred swaps or forward swaps
⁃ (where the swap does not commence immediately and
⁃ so the parties do not begin to exchange interest payments
⁃ until some future date) 


constant maturity swaps: CMs

where the floating leg of the swap is
for a longer maturity than
the frequency of payments). 
Whereas in a vanilla interest rate swap
the floating leg might be a 6-month interest rate paid,
and reset, every 6 months,
in a CMS
the floating leg might be
a 5-year market interest rate
but paid, and reset
to current market levels, every 6 months. 
The duration of the fixed flows
under the swap remains constant
during the swap’s life). 
For example,
imagine a UK investor believes that
the difference between the 6-month LIBOR rate
will fall relative to the 3-year swap rate for £ sterling.
To take advantage of this, the investor can buy a CMS,
paying the 6-month LIBOR rate
and receiving the 3-year swap rate.


extendable swaps

where one party has the option to
extend the life of the swap
beyond a specified period) 


puttable swaps

(where one party has
the option to terminate the swap


zero coupon swaps are

he most widely used variation by institutional investors
as they allow more precise hedging
of interest rate risk
than par swaps alone would permit.


Currency swaps 

exchanging principal and interest payments
in one currency
for principal and interest payments in another currency.

This requires that
a principal be specified
n each of the two currencies –

these are usually chosen to be
approximately equivalent
using the exchange rate at the time the swap is initiated.

The principal amounts are
usually exchanged at the beginning and
at the end of the life of the swap –

as the companies involved
normally want to borrow the actual currencies. 


a currency swap can be used to

transform borrowings in one currency into
borrowings in another currency.
It can also be used to transform the nature of assets.


the currency swap can be valued as

(in the absence of default risk)
as a position in two bonds.
The value can therefore be determined from interest rates
in the two currencies and
the spot exchange rate.


Total return swaps

following the growth in structured products
and exchange traded fund markets,

total return swaps have become commonplace.

The most common approach is for
the receiver to receive
the total return on a reference asset,

in return for paying
the reference floating rate
(eg 3 month LIBOR) plus or minus an adjustment.

The adjustment will allow for
the net effect of
hedging costs,
inancing costs and
dealing spreads.


Total return swaps are available on

a wide range of
interest rate,
currency and
commodity assets.


RPI and LPI swaps

(swapping fixed rate for “index” return)


An RPI swap

⁃ links one set of payments
⁃ to the level of the retail price index (RPI).


⁃ Under an LPI (limited price indexation) swap

⁃ the payments are again linked to the RPI,
⁃ but capped at a maximum rate,
⁃ which is normally set at between 0% and 5% pa.


cross-currency swaps or currency coupon swaps

⁃ (exchanging a fixed interest rate in one currency
⁃ for a floating interest rate in another currency.
⁃ This is a combination of
⁃ an interest rate swap and
⁃ a currency swap. )