Part 7 - Swaps Theory

Question 1

Implicit loans meaning

Answer 1

In the context of swaps, implicit loans emerge because the swap rate is fixed over the contract period, while the forward curve fluctuates, leading to instances where the swap rate payer alternately overpays or underpays compared to the forward price, depending on the forward curve’s shape and its intersections with the swap rate.

Question 1

Intuition of swap rate - what is it thought of as?

Answer 1

Effectively the swap rate can be thought of as a weighted average of the forward curve. The weight placed on each point of the forward curve is proportional to that point’s discount factor. Earlier forward payments are valued more highly in a PV, so will impact the swap rate more. Later forward payments are discounted heavily in the PV, so will impact the 1 swap rate less. Therefore the average will be tilted towards the short end of the forward curve.

Question 2

Interest rate swap - interpret as an expression

Answer 2

• One way to interpret this expression for the swap rate is as the coupon rate on a par coupon bond

Question 3

Deferred swap intuition

Answer 3

• Notice, therefore, that the intuition of a swap being a weighted average of the forward curve still holds, but that the average is now taken over a different interval of the forward curve

Question 4

Amortizing swaps meaning

Answer 4

Decreasing

Question 5

Intuition of amortizing swaps

Answer 5

the intuition of the swap being a weighted average of the forward curve still holds, but that average is now weighted not just by the time value of money, but also by the size of the amount being exchanged in that period.