Chapter 9 - Introduction to Swaps

Question 1

What is a commodity swap?

Answer 1

A swap in which one counterparty
agrees to make fixed periodic
payments to a second counterparty for
the use of a predetermined amount of
a certain commodity. Simultaneously,
the second counterparty agrees to
make periodic payments to the first
counterparty which are based on the
same amount of a certain commodity
but calculated at a floating unit price.

Question 2

What is a credit default swap?

Answer 2

The exchange of two cash flows – a
fee payment and a conditional
payment – which occurs only if certain
circumstances are met. A CDS is credit
insurance; it transfers credit risk.

Question 3

What is a credit derivative?

Answer 3

Financial instruments that derive their
value from an underlying credit asset
or pool of credit assets, such as bonds
or mortgages, and are designed to
transfer and manage credit risk.

Question 4

What is a currency swap?

Answer 4

In its simplest form, a plain fixed-
for-fixed currency swap agreement
is an agreement between two
counterparties in which the first
counterparty agrees to exchange
principal and fixed-rate interest
payments on a loan denominated
in one currency with the second
counterparty’s principal and fixed-
rate interest payments on a loan
denominated in a different currency.

Question 5

What is an equity swap?

Answer 5

An equity swap effectively creates
a “synthetic” equity position. In an
equity swap, counterparty A will make
interest payments to counterparty B
calculated at a fixed rate of interest
on a notional amount of principal for
the duration of the swap. In return,
counterparty B will make payments
to counterparty A equal to the return
(or some fraction thereof) of the same
notional amount of the agreed upon
equity index.

Question 6

What is an interest rate swap?

Answer 6

An interest rate swap involves two
counterparties, A and B. Under a plain
vanilla interest rate swap, counterparty
A agrees to pay counterparty B
periodic cash flow equal to interest,
calculated at a predetermined
fixed rate, on a notional principal
throughout the life of the swap.
Meanwhile, counterparty B agrees to
pay interest, calculated at a floating
rate, on the same notional principal to
counterparty A. Only net cash flows
are exchanged.

Question 7

What is a plain vanilla interest rate swap?

Answer 7

A term used to describe the most basic
type of interest rate swap

Question 8

What is a swap?

Answer 8

A private, contractual agreement
between two parties used to exchange
(swap) periodic payments in the future
based on an agreed to formula. Swaps
are essentially equivalent to a series of
forward contracts packaged together.

Question 9

What is a swap dealer?

Answer 9

A swap dealer is a financial
intermediary who facilitates the entire
swap process by finding and bringing
together the two sides of a swap
agreement and tailoring a product to
meet the specific needs of the end-
users. The swap dealer simplifies the
process by acting as a counterparty for
each of the two end-users.

Question 10

What is warehousing?

Answer 10

When a swap dealer enters into an
agreement with one party, it typically
takes some time before it finds and
arranges an offsetting agreement with
another party. In such cases the dealer
has to warehouse the swap and hedge
its exposure

Question 11

Explain what a swap is.

Answer 11

A swap is a particular type of OTC forward contract. In the most basic type of interest rate swap (referred to as
a “plain vanilla interest rate swap”) two parties agree to “swap” cash flows based on two different interest rates
on a certain principal amount referred to as the “notional” amount.

Question 12

List the differences and common features of a swap versus standard forward agreements.

Answer 12

The following table compares swaps and standard forward agreements:

Swaps Forward Agreements
Fixes or establishes a price for a specified series of
time periods in the future
Fixes or establishes a price for a specific point in time
in the future
Potential cash payments on each coupon payment
date or upon triggering of a credit event
One cash payment on the settlement date
Cash payment is the difference between the
reference rate and the fixed rate
Cash payment is the difference between the contract
rate and the current rate

Question 13

Describe the role of a swap dealer.

Answer 13

The role of a swap dealer is to facilitate the entire swap process by finding and bringing together the two parties
of a swap agreement and designing a product tailor-made to the needs of the two end-users.

Question 14

Describe the four areas of focus of the OTC derivatives market reform

Answer 14

The four areas of focus of the OTC derivatives market reform are:
* All standardized OTC derivatives should trade on exchanges or electronic trading platforms.
* All standardized OTC derivatives should be cleared through central counterparties.
* All OTC derivatives should be reported to trade repositories.
* Non centrally cleared derivatives should be subject to higher capital requirements

Question 15

Why is the principal amount on which a swap is based referred to as a “notional” principal amount?

Answer 15

It is referred to as “notional” because the principal amounts are not generally exchanged in a swap transaction
and the notional amount is only used in determining the amount of the periodic payments.

Question 16

How is a swap dealer generally paid for the services it provides in facilitating a swap?

Answer 16

A swap dealer charges a fee in the form of a bid-ask spread on its fixed-rate quotes.

Question 17

Explain what it means for a dealer to “warehouse” a swap.

Answer 17

When a dealer warehouses a swap, it is taking on one side of the swap without entering into a second
offsetting swap. This usually occurs when a swap dealer is unable to find a third party to assume the
“counterparty role” to a swap that the swap dealer has already entered into. Under these circumstances, the
swap dealer must temporarily assume the counterparty role and places the swap on its own balance sheet.

Question 18

List four typical uses of swaps

Answer 18

Uses of swaps include:
* risk reduction/hedging;
* cost reduction;
* creation of synthetic instruments; and
* speculation.

Question 19

What four areas of focus are addressed by the OTC derivatives market reforms introduced by the Group of
Twenty (G20) countries?

Answer 19

The OTC derivatives market reforms introduced by the G20 countries focus on the trading of standardized OTC
derivatives, the clearing of standardized OTC derivatives, the trade reporting of OTC derivatives and the capital
requirements for non centrally cleared derivatives.