Lecture 11: interest rate swaps

Question 1

What are interest rate swaps?

Answer 1

where two counterparties agree to exchange periodic payments.
can be for multiple reasons, mainly tax.

Question 2

what are the two counterparties called

Answer 2

One party is the fixed rate payer or floating rate receiver, the other party agrees to pay a floating rate based on reference rate and is called the floating rate payer/fixed rate receiver.

Question 3

Notional amount is

Answer 3

principal value of which $ interest payments are based off

Question 4

Reset frequency is

Answer 4

frequency at which the floating rate payer must pay.

Question 5

default risk with interest swap

Answer 5

Risk that a party may not fulfill its obligation

Question 6

2 ways to interpet a swap position

Answer 6

1. a package of forward/futures contracts

2. as a package of cashflows from buying/selling cash market instruments.

Question 7

swaps vs forward contracts

Answer 7

swaps are more transactionally efficient, one transaction can establish a payoff equivalent to a package of forward contracts

longer life

swaps provide more liquidity than forwards.

Question 8

Trade date

Answer 8

date that counterparties commit to the swap

Question 9

effective date

Answer 9

date swap begins to accrue interest

Question 10

maturity date

Answer 10

date swap stop accruing interest

Question 11

how is a swap quoted to the market

Answer 11

Swap dealer sets the floating rate equal to the index and then quotes the fixed rate that will apply.

Offer price a dealer would quote the fixed rate payer would be to pay 8.85% and receive LIBOR flat

bid price dealer would quote fixed rate receiver would be pay LIBOR flat and receive 8.75%

In this scenario Bid ask spread is 10BPS