7 - swaps Flashcards
What is a swap?
A thing that has been or may be given in exchange for something else
What is a vanilla swap?
Is the simplest form of swap
- standardised product characteristics
- standardised deal structure
- standardised documentation
What is an exotic swap?
Is a transaction in which at least one of the standardised features of
the Vanilla Swap is broken
» Simple Exotic one/two standardised features are amended
» Complex Exotic several standardised features are amended
What is a vanilla interest rate swap?
The exchange of cashflows arising from fixed interest rate interest falling due at a
pre-determined date for cashflows arising from interest falling due at a floating
interest rate over the same time period for the same principal amount.
What are vanilla currency swaps?
The exchange of principal and interest payments in one currency for principal and
interest payments in another currency.
What is a swap?
-They are flexible
-Given that they are a series of periodic payments/ receipts (cashflows) throughout the period of
the swap contract they can be used to transform just about any type of cashflows between
two counterparties!
The cashflows that can be swapped are limited only by the imagination of the counterparties
Give some examples of swap transactions
Fixed interest mortgages
» Fixed interest savings accounts
» Insurance
» Fixed price utilities
» Fixed price servicing on cars
What drives desire for swap transactions?
Risk.
e.g.
Fixed interest : Swapping potentially variable interest cost mortgages for certain,
fixed costs, over a period of time.
Insurance : Swapping a fixed monthly payment to cover a potentially large certain
cost.
Fixed Price Car : Swapping a fixed monthly payment to cover servicing potentially
large, variable, annual cost.
What are interest rate swaps?
Interest rate swaps are bilateral agreements between two counterparties to exchange interest payments in a common currency calculated using specified rules exchange on a given notional principal
What are the use of swaps?
Exploit comparative advantages → theory of comparative advantage (Ricardo)
» Analyse alternative funding costs → e.g. fixed vs floating
» Manage Risk/Maturity → assets and liabilities at different fixed/floating bases
» Speculate → notional is not swapped so cashflows become future
obligations or gains
Swaps are also transformative:
» Transform Risk → As we have seen in the example of Ava & Sean Limited and Riz Key
& Ness Limited, each company transformed their risk
» Transform a Liability → Transform the basis of a liability such as credit/loan repayments
» Transform an Asset → Transform the basis of an asset, for example switching a fixed-income
asset (such as a bond) to a floating rate income
How do you value a interest rate swap?
At the commencement of an Interest Rate Swap, it is assumed that the value of the
swap is neutral – that neither party will benefit at the expense of the other.
This is not the case through the life of the Swap. As interest rates change, the
perceived risk/security of fixed/floating interest rates changes.
Post-inception we need a method for valuing Interest Rate Swaps….look at pp
coupon formula
coupon = rate x time x face value
The price at which a swap should take place can be calculated using the NPV
discount factors for a swap counterparty. These discount factors are based upon the
rate of return a counterparty needs to receive, which will be determined by:
» The cashflows they are seeking to swap
» The timings of the cashflows they are seeking to swap
» Their cost of capital and margin/return requirements
What are the strategies used for hedging swap exposure?
» Caps A cap is a financial instrument that places a maximum limit on the rate of
interest payable/receivable for a swap counterparty
» Floors A floor is a financial instrument that places a minimum limit on the rate of
interest amount payable/receivable for a swap counterparty
» Collars This type of financial instrument is a combination of both a Cap and a
Floor (the principle being the Floor subsidises the Cap). Where a Floor
matches the cost of the Cap it is known as a “Zero-Cost Collar”
