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Master Class: Derivative Products: Swaps

Swaps

This is an agreement between two parties, usually institutions, to exchange cash flows according to a predefined calculation at some specified periodic intervals in the future. The calculation may be based on the future value of interest rates, foreign exchange rates or some other market variable. Like forward and futures contracts both parties to the contract are obligated to perform their end of the deal. Also like forward and futures contracts swaps are priced to have a value of zero at inception.

Interest Rate Swap

In a standard (plain vanilla) IRS, the buyer of the contract, usually a company, pays a predetermined fixed rate (F) payment leg and receives a floating rate(R) payment leg which is usually linked to some index (such as LIBOR).

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Both payments are based on the same notional amount (Q) and period of time. The principal amount is not exchanged in an IRS. Usually there is a difference check at each payment point and the party that is obligated to pay more will make the payment of the difference between the two cash flows.

The net cash flow for the buyer of the contract at each payment date is:

Cash flowt=Q×(Rt-1-F)× days

Where t-1 is the payment date on which the floating rate interest was observed and is one payment date prior to the payment date on which the net cash flow is paid. “days” are the period of time in the interest rate period (in years) based on the appropriate day count convention.

The fixed rate in the IRS that makes the value of the IRS zero at inception is known as the swap rate.

Currency Swap

A currency swap exchanges the principal and interest payments in one currency with the principal and interest payment in another currency. The principals will be exchanged at commencement and expiration of the contract. At the initial stage the principals are usually equivalent based on the prevailing exchange rates at that point in time. However at the expiration date even though the principal amounts will not change, their actual values could be significantly different based on how the two currencies have moved in relation to each other.

Fixed for fixed currency swap

The interest payments for both currencies are based on fixed rates.

Floating for floating currency swap

The interest payments for both currencies are based on floating rates.

Cross-currency interest rate swap

The floating interest payments in one currency are exchange for the fixed interest payments of the other currency.

Variations to Plain Vanilla Swaps

Step-up Swaps

The notional principal on which the interest rate payments are determined are increased at certain predetermined times in the future.

Amortizing Swaps

The notional principal on which the interest rate payments are determined are decreased at certain predetermined times in the future.

Basis Rate Swap

In the swap agreement both interest rates in the swap are floating rates. Parties involved in the agreement pay cash flows based on one floating rate and receive cash flows based on another floating rate.

Forward or Deferred Swaps

These swaps obligate the holder to enter into an interest rate swap at a predetermined time in the future.

Compounding Swaps

Usually there is only one payment/ settlement date specified for these contracts. However, besides specifying the interest rates at which the periodic interest amounts will be determined the contract also specifies the annual compounding rate and period of compounding at which these interest amounts will be accrued forward over the life of the contract. At expiration of the swap the total accrued interest amounts will be exchanged.

LIBOR-in- Arrears Swap

As mentioned before, in a standard swap of fixed for the net cash flow determined on a payment date is based on the floating interest rate observed on the prior payment date. In this swap the two dates are the same, i.e. the net cash flow based on the floating interest rate observed on a payment date and paid on that payment date and not the next one.

Constant Maturity Swap

The floating rate used in the swap is based on the swap rate applicable to a swap with a certain maturity.

Constant Maturity Treasury Swap

The floating rate used in the swap is based on the yield applicable to a Treasury bond with a certain maturity.

Differential Swap or Quanto

The floating rate used in the swap is observed in one currency but is applied to a principal of another currency.

Variance or Volatility Swap

The variance or volatility realized during the period is exchanged for a fixed volatility or variance. Payoffs are based on the same notional principal for both legs.

Equity Swap

Under this contract the payments based on the return realized on an equity index or equity portfolio are exchanged for fixed or floating interest rate payments.

Commodity Swap

Under this contract one leg pays the other leg an amount based on a fixed commodity price and receives cash flows based on the market commodity price. The prices are applicable to a specified number of units of the commodity that is the same for both legs.

Asset Swap

One leg to the swap pays the coupon on a bond, the other side makes payments based on a floating interest rate with spread.

Accrual Swap

The interest payments on one of the legs are based on an interest rate that only accrues on those days when the floating interest rate is within a specified range. Days when the floating rate is not in this specified range the interest rate will not be taken into account when determining the interest rate payment.

Cancelable Swap

This is an option that allows the holder to terminate the swap at specified dates prior to maturity.

Extendable Swap

This is an option that allows the holder to extend the life of the swap at specified dates.

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