Swaps Flashcards
what is a swap
A way to hedge a risky STREAM of cash flows
Relate swaps to forward
A forward is a single payment swap
is forward price represented in todays worth?
No, it is not present value. It represent what we need to pay AT THE LATER TIME. If we want to make computations, either we must change the forward price to present value OR change all other values to future value at t=T.
define prepaid swap
Pay today to obligate the other party to make deliveries in a sequence of dates later.
issue with prepaid swaps
credit risk at the party that holds teh asset or commodity. Perhaps it is risky in regards to whether they will actually be able to dliver the shit or not.
Benefit of swap vs forwards?
single transaction, very clean
What is the typical way for swaps to make payment
payments each year, or whatever interval is specified. the most common way is to pay the same currency amount each period. Equal payments, we call this.
what is crucial regarding equal payments?
The payment must equate the present value of the would-be forwards:
for instance:
x/1.06 + x/1.065^2 = Present value forwards
Present value forwards are given by:
forward year 1 + forward year 2 (both discounted):
110/1.06 + 111/1.065^2 = 201.638
Thus we get:
x/1.06 + x/1.065^2 = 201.638
Isolate x and solve to get:
x = 110.483
what value is acceptable for swap price?
Any price that satisfy the fact that the present value of all payments equal the present value of the forward prices.
what happens during financial settlement of swaps?
we have the swap price, for instance with equal payments (110.483).
Then the counterparty will pay the difference between the swap price and the spot price at each period. If the difference is negative, meaning that the spot price is larger than the swap price, the counterparty pays us this, while if it is positive, we pay them.
the key thing to remember is that the party that is long the asset should benefit from asset increasing in value, which would happen when spot is greater than swap price.
elaborate on swap as a loan
with equal payments, we observe that early on, the swap price is less than the forward price, and opposite later. This means that taking the long position in a swap entails an implicit loan where we have the advantage of paying less at first, and then more later.
Thus, a swap carry a loan. this loan has a certain interest rate, and the ledning technically starts at the first payment, so it skips the initial time t=0. Goes from year=1 and onward.
key to remember regarding hedging a swap
Simply entering teh opposite side using forwards deos not fully hedge the position as a result of the implicit loan effect.
We are actually exposed to interest rate risk.
