Swaps Flashcards
Explain a swap contract
Under a swap contract two parties agree to exchange a series of cash-flows
according to a pre-defined formula. In most cases an intermediary body such as
an investment bank may facilitate the swap by looking after the precise
administration details. The intermediary will charge a
commission fee
What capital is an interest rate swap based on
Capital is notional and not exchanged. Notional capital is in same currency. Used to determine the interest payments
How does an interest rate swap work - what is exchanged
One party to the swap will usually pay the other party payments based on a fixed
interest rate and will receive from the other party payments based on a floating
(variable) interest rate.
What desire must be present for an interest rate swap to occur
For the swap to work there must be a desire on one party
to increase its exposure in the floating rate market (in long run will decrease rate) and a corresponding desire
on the other party to increase its exposure in the fixed interest rate market (reduces uncertainty)
Apart from exposure desires what might be another reason for entering a swap contract for both parties
It may also be that the swap contract can
reduce both parties overall (net) cost of borrowing.
Define LIBOR
London InterBank Offered Rate. It is a benchmark for short-term interest
rates and so we can consider libor x%
cost of borrowing in floating rate terms. (CHANGES VERY FREQUENTLY SO PROXY FOR FLOATING RATE)
2 reasons companies enter interest swap contracts
Increase each others exposure to capital market, and also to
Reduce each others (net) cost of borrowing (if this is possible, which it is
with these rates).
Define the spread
The difference between the fixed borrowing rate of comapny A and B and the difference between the floating borrowing rate of A and B
Define gross comparative advantage
The (total) gross comparative advantage that an Interest-Rate Swap will induce
here is the difference between the spreads, usually difference in %s
Define relative comparative advantage
If in one market (where B is dominant) the spread between A and B is smaller than the other market forv B so B has comparative advantage
Define total net comparative advantage
Gross comparative advantage - commission (or management charge).
What is key for interest rate swaps
No exchange of principal between both parties
will take place under an Interest Rate Swap.
Explain the expected returns, loss, advantages brough on by swap
The swap will be priced so that the (expected) present value of the cash-flows is slightly negative
for the investor, (usually the company), and slightly positive for the issuing organisation (usually
the bank). The difference represents the price the investor is prepared to pay for the advantages
brought by the swap, the expenses involved and the issuers expected profit margin
Explain market risk faced in the swap
This is the risk that market conditions will change
so that the present value of the net outgo under the agreement increases (for that counterparty).
Explain the credit risk faced in a swap contract
Each counterparty to a swap faces a credit risk. This is the risk that the other counterparty will
default on its payments. In general, this will only occur if the swap has a negative value to the
defaulting party.
