FNAN 406: Ch. 7

Swap

An OTC derivatives agreement between 2 parties to exchange cash flows in the future according to a prearranged formula; the exchange of a fixed-rate bond for a floating-rate bond.

Deferred swap

An agreement to enter into a swap at some time in the future (also called a forward swap). A swap where the parties do not begin to exchange interest payments until some future date.

Constant maturity Treasury swap (CMT swap)

An agreement to exchange a LIBOR rate for a particular Treasury rate.

Credit default swaps

An instrument that gives the holder the right to sell a bond for its face value in the event of a default by the issuer.

LCH.Clearnet daily valuations

LCH.Clearnet is the largest Central Clearing Party for interest rate swaps (formed by a merger of the London Clearing House and Paris-based clearnet). It uses OIS discounting for its daily valuations (OIS=overnight indexed swaps).

Function of currency swaps

One party agrees to pay interest on a principal amount in one currency. In return, it receives interest on a principal amount in another currency.

Function of interest rate swaps

One party agrees to pay the other party interest at a fixed rate on a notional principal for a # of years. In return, it receives interest at a floating rate on the same notional principal for the same period of time.

Constant maturity swap (CMS)

A swap where a swap rate is exchanged for either a fixed rate or a floating rate on each payment date. An agreement to exchange a LIBOR rate for a swap rate.

Step-up swaps

A swap where the principal increases over time in a predetermined way. This might be designed to correspond to drawdowns on a loan agreement.

Equity swaps

A swap where the return on an equity portfolio is exchanged for either a fixed or a floating rate of interest. It is an agreement to exchange the total return (dividends and capital gains) realized on an equity index for either a fixed or a floating rate of interest.

How can interest rate swaps be used?

-Can be used to transform a floating-rate loan into a fixed-rate loan, or vice versa. -Can be used to transform a floating-rate investment to a fixed-rate investment, or vice versa.

How can currency swaps be used?

-Can be used to transform a loan in one currency into a loan in another currency. -Can be used to transform an investment denominated in one currency into an investment denominated in another currency.

2 most common types or swaps:

1. Interest rate swaps 2. Currency swaps

Credit risk in swaps

A FI is exposed to credit risk when it enters into a pair of offsetting swaps with different counterparties. If one of the counterparties defaults when the FI has positive value in its swaps with that counterparty, the FI loses money bc it still has to honer its swap agreement with the other counterparty.

Function of Interest Rate Swaps:

A company agrees to pay cash flows equal to interest at a predetermined fixed rate on a notional principal for a predetermined # of years. In return, it receives interest at a floating rate on the same notional principal for the same period of time. Most common type of interest rate swap is a "plain vanilla" swap.

Fixed-for-floating currency swaps

A floating interest rate in one currency is exchanged for a fixed interest rate in another currency; regarded as a portfolio consisting of a fixed-for-fixed currency swap and a fixed-for-floating interest rate swap.

How are currency swaps valued?

Currency swaps are regarded as a portfolio of forward contracts.

How can equity swaps be used by portfolio managers?

Equity swaps can be used by portfolio managers to convert returns from a fixed or floating investment to the returns from investing in an equity index, and vice versa.

What is fixed-for-fixed currency swaps used for?

Fixed-for-fixed currency swaps are used to transform borrowings in one currency to borrowing in another currency; can be viewed as a forward foreign exchange contract.

When are the principal amounts in a currency swap usually exchanged?

In a currency swap the principal amounts are usually exchanged at both the beginning and the end of the life of the swap. For a party paying interest in the foreign currency, the foreign principal is received, and the domestic principal is paid at the beginning of the life of the swap. At the end of the life of the swap, the foreign principal is paid and the domestic principal is received.

When are the principal amounts in an interest rate swap usually exchanged?

In an interest rate swap the principal amount are NOT usually exchanged.

What do both fixed-for-fixed and fixed-for-floating currency swaps involve?

Involve an initial exchange of principal in the opposite direction to the interest payments and a final exchange of principal in the same direction as the interest payments at the end of the swaps life.

Fixed-for-fixed currency swaps

Involves exchanging principal and payments at a fixed rate of interest in one currency for principal and payments at a fixed rate of interest in another currency; requires the principal to be specified in each of the 2 currencies. Also called currency swap agreement.

Most commonly used reference rate for floating rate loans in the US:

Prime is the reference rate of interest for floating rate loans in the domestic financial market; LIBOR is a reference rate of interest for loans in international financial markets.

Swap rate

The fixed rate in an interest rate swap that causes the swap to have a value of zero.

When are principal amounts usually exchanged in a fixed-for-fixed currency swap?

The principal amounts are usually exchanged at the beginning and at the end of the life of the swap.

Notional principal

The principal used to calculate payments in an interest rate swap; the principle is "notional" bc it is neither paid not received.

How are interest rate swaps valued?

The swap is decomposed into a long position in one bond and a short position in another bond.