Nature of Swaps

A swap is an agreement to exchange cash flows at specified future times according to certain specified rules

Two popular swaps

plain vanilla interest rate swaps fixed-for-fixed currency swaps

plain vanilla interest rate swaps In this swap a company agrees to pay cash flows equal to interest at a predetermined fixed rate on a notional principal for a number of years. In return, in receives interest at a floating rate on the same notional principal for the same period of time. floating rate The floating rate in most interest rate swap agreements is the London Interbank Offered Rate (LIBOR).

The Nature of Swap Rates

Six-month LIBOR is a short-term AA borrowing rate. The 5-year swap rate has a risk corresponding to the situation where 10 six-month loans are made to AA borrowers at LIBOR. This is because the lender can enter into a swap where income from the LIBOR loans is exchanged for the 5-year swap rate.

Market makers

Many large financial institutions act as market makers for swap. They are prepared to enter swap without having an offsetting swap with another counterparty. Market makers must carefully quantify and hedge the risks they are taking. Bonds ,FRA ,interest rate futures are example of the instruments that they can be used for hedging by swap market makers.

Confirmation

A confirmation is the legal agreement underlying a swap and is signed by representatives. International Swap and Derivatives Association (ISDA) in New York. The confirmation specifies that the following business day convention is to be used and that the US calendar determines which days are business days and which are holiday.

Currency swaps

In its simplest from ,this involves exchanging principal and interest payments in one currency for principal and interest payments in another.

Typical Uses of a Currency Swap

Conversion from a liability in one currency to a liability in another currency Conversion from an investment in one currency to an investment in another currency

Valuation of Currency Swaps

Like interest rate swaps, currency swaps can be valued either as the difference between 2 bonds or as a portfolio of forward contracts.

Valuation of interest rate swaps

Interest rate swaps can be valued as the difference between the value of a fixed-rate bond and the value of a floating-rate bond Alternatively, they can be valued as a portfolio of forward rate agreements (FRAs)

Typical Uses of an Interest Rate Swap

Converting a investment from fixed rate to floating rate floating rate to fixed rate

4.7% LIBOR- 0.3%

LIBOR- 0.2% 4.8%

Typical Uses of an Interest Rate Swap

Converting a liability from fixed rate to floating rate floating rate to fixed rate

LIBOR+0.1% 5.1%

5.2% LIBOR+0.2%

Comparative Advantage
General Electric wants to borrow AUD Qantas wants to borrow USD

Credit Risk

A swap is worth zero to a company initially. At a future time its value is liable to be either positive or negative. The company has credit risk exposure only when its value is positive. Some swaps are more likely to lead to credit risk exposure than others. What is the situation if early forward rates have a positive value? What is the situation when the early forward rates have a negative value?
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Other Types of Swaps

Floating-for-floating interest rate swaps, amortizing swaps, step up swaps, forward swaps, constant maturity swaps, compounding swaps, LIBOR-in-arrears swaps, accrual swaps, diff swaps, cross currency interest rate swaps, equity swaps, extendable swaps, puttable swaps, swaptions, commodity swaps, volatility swaps..

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Dhiren Datta Vishal Salve Aditya Gupta Vipul Mandaliya Ashish Vaghasiya

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Karan Rao

The End