Risk Management - Swaps

Question 1

What is the duration of a swap, floating-payer and fixed-payer?

Answer 1

D_swap = D_asset - D_liability
D_pay floating = D_fixed - D_floating > 0
D_pay fixed = D_floating - D_fixed < 0

Question 2

Demonstrate how a firm can use a currency swap to convert a series of foreign cash receipts into domestic cash receipts.

Answer 2

1. Divide the foreign cash flow received by the foreign interest rate to determine the corresponding foreign-denominated notional principal (NP).
   a. This is the foreign NP that would have produced the foreign cash flow at the given foreign interest rate.
2. Using the current exchange rate, convert the foreign NP into the corresponding domestic NP.
3. Enter a swap with this NP.
   a. Pay the foreign cash flows received on the assets and receive the equivalent domestic amount.
   b. The amount of each domestic cash flow is determined by multiplying the domestic interest rate by the domestic NP.

Question 3

What is a payer swaption?

Answer 3

A payer swaption gives the buyer the right to be the fixed-rate payer (and floating-rate receiver) in a prespecified swap at a prespecified date. The payer swaption is almost like a protective put in that it allows the holder to pay a set fixed rate, even if rates have increased.

Question 4

What is a receiver swaption?

Answer 4

A receiver swaption gives the buyer the right to be the fixed-rate receiver (and floating-rate payer) at some future date. The holder must expect the rates to fall, and the swap ensures receipt of a higher fixed rate while paying a lower floating rate.