PS2 - Swaps Q's

Question 1

1. Describe the intuition for why the swap rate on a fixed-for-floating interest rate swap is equivalent to the coupon rate on a part coupon bond.

Answer 1

The swap rate can be shown to be a weighted average of the forward curve. A par coupon bond’s yield is the same as the coupon rate. The yield on a bond is also an average compensation required to hold the bond to maturity

Question 2

2. What is an accreting swap? How would its swap rate differ from an non-accreting swap of the same maturity?

Answer 2

An accreting swap is one where the amount of the exchange increases period by period. Its swap rate will also be an average of the forward curve, but the average will be tilted towards the back end of the forward curve, as those points will have larger exchanges.

Question 3

In a fixed-for-fixed currency swap where country A’s interest rate is higher than country B’s interest rate, who is the lender in the implicit loan, the counterparty paying in country A’s currency or the counterparty paying in country B’s currency?

Answer 3

If country A’s interest rate is higher, that means that the forward exchange rate must involve country A’s currency depreciating in the future (by CIP). Therefore, in the initial exchanges (because the interest rates are fixed), interest payments in country A’s currency will be more valuable than the interest payments in country B’s currency and vice versa for the later exchanges. Therefore, the lender will be the counterparty paying in country A’s currency.