SwapContracts

Swaps

• Swap: An agreement between two parties (“counterparties) to exchange a series of cash flows in the future– Essentially a series of forwards– Settle at each swap maturity date (often netted out)– Payments generally determined so swap initially has

zero market value• Common are

– Interest rate swaps– Currency swaps

Swaps vs. Futures

• Futures– Standardized

– Exchange-traded

– Short horizons

• Swaps– Custom tailored between counterparties

– Less regulation; potential for privacy

– Term flexibility

Interest Rate Swaps

• One party pays a fixed interest rate and receives a floating rate

• The other party pays a floating rate and receives a fixed rate

• Floating rates involve greater exposure to interest rate risk

• “Notional principal” is amount on which the interest payments are determined

Interest Rate Swaps (cont.)

• Principal is not actually exchanged -- only interest payments

• Often, only net interest payments are transacted– Avoids unnecessary transactions– Helps credit risk

• At each “settlement date,” a net payment is made, based on the difference between the two interest rates (applied to the notional principal)

Types of Swaps

• Swap curve– Swap rates for different maturities– Analogous to yield curve

• Deferred swap– Begins in future

• Amortizing swap– Covers loan with declining balance

• Accreting swap– Covers loan with increasing balance

Q: Swaps – Fixed rate Calculation(From Exam FM Fin Econ Sample Questions)

Q: Swaps – Cash Flow Calculation(From Exam FM Fin Econ Sample Questions)

Q: Swaps – Cash Flow Calculation(From Exam FM Fin Econ Sample Questions)