Swaps Flashcards
(8 cards)
What is a swap?
An over-the-counter derivative agreement between two companies to exchange cash flows at several dates in the future (directly or via a financial intermediary). Usually the calculation of the cash flows involves the future value of an interest rate, an exchange rate, or other market variable.
What is an interest rate swap?
A swap where interest at a predetermined fixed rate, applied to a certain principal, is exchanged for interest at a floating reference rate (e.g., LIBOR), applied to the same principal.
Note that the principal itself is not exchanged in an IRS.
What is the purpose of interest rate swaps?
To convert a liability or an investment from fixed rate to floating rate (or vice versa).
What is comparative advantage (not to be confused with absolute advantage)?
A company’s ability to borrow or invest at a lower opportunity cost (i.e., loses less opportunities) in one market (floating or fixed) than in another market relative to its counterparty in a swap contract.
What is the difference between the credit risk and the market risk in a swap?
Credit Risk: The risk that a counterparty fails to make payments under the swap agreement (defaults on the contract). It depends on the creditworthiness of the parties and grows with the positive market value of the swap.
Market Risk: The risk that changes in interest rates, exchange rates, or prices will affect the value of the swap. This risk is not due to default, but due to market volatility.
A complication is that the credit risk in a swap is contingent on the values of the market variables. For example, suppose that a company has a single bilaterally cleared swap with a counterparty. The company has credit risk only when the value of the swap to the company is positive.
Explain why a bank is subject to credit risk when it enters into two offsetting swap contracts.
At the start of the swap, both contracts have a value of approximately zero. As time passes, it is likely that the swap values will change, so that one swap has a positive value for the bank and the other has a negative value for the bank. If the counterparty on the other side of the positive-value swap defaults, the bank still has to honour its contract with the other counterparty. The two counterparties are not contractually linked, so the default of one does not release the bank from the other. The bank is liable to lose an amount equal to the positive value of the swap.
A bank finds that its assets are not matched with its liabilities. It is taking floating-rate deposits and making fixed-rate loans. How can swaps be used to offset the risk?
Use a Pay-Fixed, Receive-Floating Swap. To hedge the risk, the bank can enter into an interest rate swap where:
- The bank pays fixed (to match its fixed-rate loan income)
- The bank receives floating (to match its floating-rate liabilities)
This way:
- The floating payments received from the swap move in line with deposit costs
- The fixed payments made in the swap offset the fixed loan cash inflows
What are fixed-for-fixed currency swaps?
A fixed-for-fixed currency swap is a financial agreement where two parties exchange fixed interest payments in different currencies over a set period.
Key Features:
1. Principal Exchange – At the start, both parties exchange a fixed amount (principals) in their respective currencies.
2. Fixed Interest Payments – Each party pays a fixed interest rate on the principal they received, in that currency.
3. Final Principal Exchange – At the end of the swap, the principal amounts are exchanged back at the original rate, reversing the initial exchange.
