Swaps Flashcards
What is a Swap?
Interest Rate Swap
Commodity Swap
Currency Swap
Credit Default Swap
A swap is an OTC agreement between to exchange cash flows at regular intervals until a termi-nal date. There are different general types of swaps:
- Interest rate swap: Agreement to exchange a fixed rate of interest for a floating rate of in-terest on a given notional at given future dates.
- Commodity swap: Agreement to buy/sell a fixed quantity of the underlying at a pre-determined price at pre-specified dates.
- Currency swap: Agreement to exchange interest payments and principal at given future dates in two different currencies.
- Other: Credit default swaps, inflation swaps, dividend swaps, variance swaps, etc.
Swap terms (rates) are usually set so neither party pays the other to enter a swap, i.e., at incep-tion, the swap is at par. After the swap has been entered, it can become an asset or a liability to either party.
swap vs. forward
Swaps are a sequence of forwards, combined with borrowing and lending. Forwards involve de-livery of the underlying while swaps exchange cash flows based on underlying.
Par Swap Rate
The par swap rate is a weighted average of the forward rates, where the weights are discount factors
Fixed for Floating Interest rate swap
The most common type of interest rate swap in which two counterparties swap fixed-for-floating interest payments on a given notional at predetermined future dates. The notional itself it not exchanged. The fixed rate (swap rate) is set up front. The floating rate is typically the n-month LIBOR (where n is the interval between swap payments, often 3 months). Interest payments are standardly netted. Note that there is no uncertainty about the first exchange of payments, as it is predetermined by the LIBOR rate at the time the swap begins.
Typical uses of an Interest Rate Swap:
Converting a liability (loan) or asset (investment) from fixed rate to floating, or vice versa. Utilis-ing comparative advantages.
Swap Rate
The average of (a) the fixed rate a swap market maker is prepared to pay in exchange for receiv-ing LIBOR (bid rate) and (b) the fixed rate that it is prepared to receive in return for paying LI-BOR (offer rate). Swap rates are close to risk-free in normal market conditions.
Comparative Advantage
consider the use of an interest rate swap to transform a liability. It is argued some companies have a comparative advantage when borrowing in fixed-rate market, whereas other companies have a competitive advantage in floating-rate markets. As a result, the company may borrow fixed when it wants floating, or vice versa. The swap is used to transform the loan.
Bootstrap zero-coupon yield curve using LIBOR/Swap rates
When the fixed rate is the swap rate where the principals are added to both sides on the final payment date, the swap is an exchange of a fixed rate bond for a floating rate bond. The float-ing-rate bond is worth par assuming LIBOR discounting, and the swap is worth zero, so the fixed rate bond is also worth par. Swap rates define par yield bonds that can be used to bootstrap the LIBOR zero curve.
Fixed-for-fixed currency swaps:
A swap that involves exchanging principal and interest payments at a fixed rate in one currency for principal and interest payments at a fixed rate in another currency. A currency swap agree-ment requires the principal to be specified in each currency. The principal amounts are usually exchanged at the beginning and at the end of the life of the swap. Usually, the principal amounts are chosen to be approximately equivalent using the exchange rate at the swaps initi-ation. When they are exchanges at the end of the life of the swap, their values can be different.
Credit Default Swap
A credit default swap (CDS) is an insurance against the default of an underlying entity (reference issuer). The protection buyer pays a quarterly insurance premium (a CDS spread) to the protec-tion seller until whichever comes first: (a) expiration of contract or (b) default of reference is-suer. In case of default, the protection seller pays a compensation to the protection buyer.
The compensation is typically the difference between the value of the defaulted bond and the insured face value. Settlement is either through physical delivery or through cash settlement. Typically, more than one reference bond is specified and the buyer therefore in case of physical delivery has a delivery option, i.e., may deliver any bond within a maturity spectrum and of same priority
Credit vs. market risk
Credit risk arises form the possibility of a default by the counterparty when the value of the contract to the financial institution is positive. The market risk arises from the possibility that market variables such as interest rates and exchange rates will move in such a way that the val-ue of a contract to the financial institution becomes negative Market risks can be hedged easily.
Currency Swap: Consider a -year annual fixed-for-fixed USD/EUR currency swap. The investor receives 4% annually on $25m and pays 3.43% annually interest on 17.5m.
The two notionals are exchanged today and at maturity.
The spot exchange rate is 1.4286$/e, the USD term structure is flat at 3.75% c.c., and EUR term structure is flat at 3% c.c.
What are the Cash Flows, the PV and the net value of the currency swap?
Year 0:
USD CF: -$25
EUR CF: €17.5
Year 1 - 4:
USD CF: $25 * 0.04 = + $1
EUR CF: €17.5 * 0.0343 = - € 0.6
Year 5:
USD CF: + $25 + $1
EUR CF: - €17.5 - €0.6
PV of USD: -25 + sum((e^-i 0.0375)1$ + 25e^-50.0375
corresponding to PV USD in EUR = 25.2 * 1/1.4286 = 17.64
PV EUR payment: -17.5 + sum((e^-i 0.03)0.6$ + 17.5e^-50.0.03 = 17.81
Net value of the currency swap is: PV USD in EUR - PV EUR in EUR = 17.64 - 17.81 = -0.17€
What is when a currency swap is struck at par?
Then the swap has a net value of zero:
PV USD in EUR = PV EUR in EUR
Fixed for floating currency swap: into fixed for fixed
Floating rate is paid annually of a principal €7M and fixed rate is received $10M.
Swap can be regarded as a portfolio of a fixed for fixed currency swap plus a EUR interest rate swap with swap rate S.
Why are interest rate swapes useful?
A commercial bank makes loans to its clients with fixed rate payments.
The bank is funded through deposits which earn a variable interest.
This creates an asset–liability mismatch in cash flows (duration gap) for the bank’s balance sheet: if interest rates go up, then payments to depositors go up but payments from the client loans stay fixed, so earnings go down
The commercial bank wishes to reduce its risk of default by reducing the interest rate risk of its earnings each period.
Solution: The commercial bank enters into an interest rate swap with an investment bank where the commercial bank pays fixed and receives floating payments to offset its duration mismatch.
