Swaps Flashcards
What is a swap?
An over-the-counter derivative agreement between two companies to exchange cash flows at several dates in the future (directly or via a financial intermediary). Usually the calculation of the cash flows involves the future value of an interest rate, an exchange rate, or other market variable.
What is an interest rate swap?
A swap where interest at a predetermined fixed rate, applied to a certain principal, is exchanged for interest at a floating reference rate (e.g., LIBOR), applied to the same principal.
Note that the principal itself is not exchanged in an IRS.
What is the purpose of interest rate swaps?
To convert a liability or an investment from fixed rate to floating rate (or vice versa).
What are the day count quote conventions for fixed and floating rate swaps?
Fixed rate swap: actual/360
Floating rate swap: (Principal x Floating rate x No. of days in accrual period)/360
What is comparative advantage (not to be confused with absolute advantage)?
A company’s ability to produce a particular good or service at a lower opportunity cost (i.e., loses less opportunities) than its trading partners.
For swaps, some companies have a comparative advantage when borrowing in fixed-rate markets, whereas other companies have a comparative advantage when borrowing in floating-rate markets.
If company A can borrow cheaper than company B but the absolute advantage of company A is weaker (smaller difference) under floating rate borrowing, company A has a comparative advantage in fixed rate markets, whereas B has a comparative advantage in floating rate markets.
What is a fixed-for-fixed currency swap?
A financial agreement where two parties exchange fixed interest payments in different currencies over a set period.
At the start, both parties exchange a fixed amount (principal) in their respective currencies.
Each party pays a fixed interest rate on the principal they received.
At the end of the swap, the principal amounts are exchanged back at the original rate.
Example: A US company borrowing in euros and a European company borrowing in USD swap their fixed-rate interest payments to hedge exchange rate risk.
The primary purpose of a currency swap is to transform a liability (or investment) denominated in one currency into a liability (or investment) denominated in another currency.
What is credit risk?
The risk that the other party defaults on the contract. It depends on the creditworthiness of the parties and grows with the positive market value of the swap.
What is market risk?
The potential financial losses that arise from the possibility that market variables such as interest rates, equity prices, and exchange rates will move in such a way that the value of a contract to the party becomes negative. This risk is not due to default, but due to market volatility.
What is the difference between the credit risk and the market risk in a swap?
Credit risk arises from the possibility of a default by the counterparty. Market risk arises from movements in market variables such as interest rates and exchange rates.
A complication is that the credit risk in a swap is contingent on the values of the market variables. For example, suppose that a company has a single bilaterally cleared swap with a counterparty. The company has credit risk only when the value of the swap to the company is positive.
Explain why a bank is subject to credit risk when it enters into two offsetting swap contracts.
At the start of the swap, both contracts have a value of approximately zero. As time passes, it is likely that the swap values will change, so that one swap has a positive value for the bank and the other has a negative value for the bank. If the counterparty on the other side of the positive-value swap defaults, the bank still has to honour its contract with the other counterparty. It is liable to lose an amount equal to the positive value of the swap.
