7.7 Pricing and valuation of interest rates and other swaps Flashcards
A swap contract
an agreement to exchange cash flows, with one party typically paying a fixed rate and the other party paying a floating rate to be determined at each payment period.
Conceptually, a swap can be thought of as being a series of forward contracts
Swaps are like forward contracts in the following ways:
No-arbitrage pricing is used to ensure that the contract has no net value to either party at initiation.
The value of the contract fluctuates after initiation and positions can be marked to market based on changes in the underlying.
Payments are based on a notional principal.
Settlement involves a net payment from the “losing” party to the “winning” party.
Payoffs are symmetrical.
Parties are exposed to counterparty credit risk.
The most commonly used swap contract
a fixed-for-floating interest rate swap
difference between swaps and FRAs
a commitment to exchange a series of payments, not just a single exchange
swap payments are made at the end of each interest period rather than at the beginning.
interest rate swaps are more popular with
corporate issuers and investors
interest rate swaps are often used by companies to change the nature of their debt obligations from fixed to floating
Swaps are also valued by investors wanting to take positions based on their views about interest rates because these instruments typically offer greater liquidity and efficiency than trading in the cash bond market.
An interest rate swap has two “legs”
explain
a fixed leg that pays the par rate and a floating leg that makes payments based on a market reference rate (MRR).
The swap’s value after initiation can be determined based on the difference between the value of these two legs.
An upward sloping forward rate reflects an expectation that
spot rates will be higher in the future
In this environment, the swap rate will be set above the relatively low rates for early periods and below the relatively high rates that are expected in later periods.
As a result, the fixed-rate receiver will expect to receive net payments in earlier periods and the floating-rate receiver will expect to receive net payments in later periods.
But the swap rate will be set at a level that makes the present value of these expectations equal for both parties at initiation.
Which of the following points is least likely to be correct with regard to the pricing and valuation of swap contracts?
A
All implicit forward contracts in a swap will have positive values
B
A swap is a series of implicit forward contracts with the expiration of each forward contract corresponding to a swap payment date
C
All implicit forward contracts in a swap are created at the fixed price that corresponds to the fixed price of a swap of the same maturity
A
All implicit forward contracts in a swap will have positive values
A swap is a series of implicit forward contracts with the expiration of each forward contract corresponding to a swap payment date. Each forward contract will be created at the fixed price that corresponds to the fixed price of a swap of the same maturity with payments made at the date as the series of the forward contract. This means that some of the forward contracts in a swap will have positive values and some will have negative values, but their combined value will be zero at initiation.
t initiation, the values of a swap contract and a forward contract are most likely to be:
A
negative.
B
zero.
C
positive.
B
zero.
Forward contracts and swap contracts have zero value at the start, as there are neither liabilities nor assets at the beginning of the contract.
Ace Limited is a financial intermediary that is active in forward and swap markets with its issuer and investor clients. You have been asked to consult on a number of client situations to determine the best course of action.
Ace enters a 10-year GBP interest rate swap with a client in which Ace receives an initial six-month GBP MRR of 1.75% and pays a fixed GBP swap rate of 3.10% for the first semiannual period. Six months later, Ace and its counterparty settle the first swap payment, and no change has occurred in terms of future interest rate expectations. Which of the following statements best describes the value of the swap from Ace’s perspective?
A
Ace has an MTM gain on the swap, because once it makes the first known net payment to its counterparty, the remainder of the future net fixed versus floating cash flows must have a positive present value from Ace’s perspective.
B
Ace has an MTM loss on the swap, because once it receives the first known payment from its counterparty, the remainder of the future net fixed versus floating cash flows must have a negative present value from Ace’s perspective.
C
While the present value of fixed and future cash flows was set to zero by solving for the swap rate at inception, we do not have enough information to determine whether the swap currently has a positive or negative value from Ace’s perspective following inception.
A
Ace has an MTM gain on the swap, because once it makes the first known net payment to its counterparty, the remainder of the future net fixed versus floating cash flows must have a positive present value from Ace’s perspective.
With respect to swap contract pricing and valuation at initiation, which of the following is least accurate?
A
The initial value of a swap is usually zero.
B
A swap is equivalent to a series of forward contracts, each created at the swap price.
C
If the present value of the payments in a swap is not zero, then the party whose stream of payments to be received is smaller has to pay the other party the present value of the difference.
With respect to swap contract pricing and valuation, which of the following is least accurate?
A
The price of a swap is usually zero at initiation.
B
The value of a swap is typically obtained through replication and the principle of arbitrage.
C
The value of a swap is equal to the present value of net cash flow payments from the swap.
A
The price of a swap is usually zero at initiation.
The value (not the price) of a swap is typically zero at initiation. The fixed swap price is determined such that the value of the swap will be zero at initiation.
