Swaps Flashcards
Swap
Multiperiod extension of forward contract
foreign exchange swap
exchange currencies on specific future dates
(this can be compared to a forward contract, which involves exchange on one specific date)
Interest rate swap
exchange of cash flows at future dates based on the difference between fixed and floating rates at those dates
is a deal whereby one exchanges a series of fixed interest rate payments for a series of floating interest rate payments or vice versa
Net CF from swap
Net CF from swap = (LIBOR-fixed rate)*par value of portfolio
swaps are useful tool to
income managers
-enable managers to quickly, cheaply and anonymously restructure the balance sheet
“pay fixed/receive floating” swap
converts a fixed rate portfolio into a floating rate portfolio
Foreign exchange swaps are used to
restructure balance sheet
- can issue US bonds to take advantage of favorable interest rates
- if firm prefers interest to be dominated in pounds, can enter a swap to exchange pounds for coupon amount annually
Swaps usually involve
a swap dealer
swap dealer
acts as a financial intermediary in the swap.
- dealer is willing to assume the opposite position from each party of the swap
- after aggregating these 2 positions, dealer will be in net position where it is immune to interest rate changes
- The dealer would charge a bid-ask spread in order to earn a profit.
It is however exposed to credit risk
obligations of each party in swap
A
B
Dealer
A: borrows money at a fixed rate, and pays the intermediary at a floating rate
B: borrows money at a floating rate and pays the intermediary a fixed rate
Dealer: intermediary receives the payments then pays fixed/floating rates to the appropriate party, and keeps a commission
Swaps trade
over the counter
eurodollar contract
an alternate that is exchange listed
- these instruments allow a fixed interest rate (the contract rate) to be swapped for a floating rate (LIBOR)
- > can be thought of as 1 period interest rate swap
- profit to the contract buyer would be: FT – F0 = (100 – LIBORT) – (100 – contract rate) = contract rate – LIBORT
one period foreign exchange swap is essentially
a forward contract on foreign exchange rate
According to the interest rate parity
forward price should be connected to spot exchange rate E0 based on
F1 = E0(1 + rUS) / (1 + rUK); Where F1 and E0 are expressed in USD per pound
-This relationship should also apply to the one period swap since the swap is equivalent to the forward contract.
2 year swap can be thought of as
being equivalent to 2 forward contracts
foreign exchange swap arrangement will require
constant exchange rate be used each year
rate should be between F1 and F2
- dollar payer of swap would be underpaying in 1st year and overpaying in 2nd
- let constant exchange rate of swap be F*, since swap is equivalent
credit risk in swap market
The credit risk is not as large as the volume of the aggregate notional principal would imply, because the exposure to credit risk is much lower
-For an interest rate swap, the credit loss would be based on the difference between the values of the fixed rate and floating rate obligations.
In a regular loan
- In a regular loan, one party provides the principal to the other. Therefore if the borrower defaults, the lender will lose the entire unpaid balance.
- On the other hand, with a swap, the money owed from party A to party B is partially offset by the money owed from party B to party A. Because of these offsetting balances, the credit loss would be less than the notional principal.
Credit default swap, CDS is structured differently from typical swap
- effectively insurance policy that is written on particular credit events
- bondholders may purchase CDS in order to transfer their credit risk exposure to swap seller
- difference from standard insurance is that swap holder does not necessarily have to hold binds that underlie CDS contract
- CDS can be used to speculate on changes in credit standing of reference firms
forward-rate agreement, FRA
an agreement to pay a specified interest rate at a future time period on a specified principal amount
*X agrees to lend Y a principal amount, Y agrees to pay interest rate rk
