Swaps & Swaptions

Question 1

What is an interest rate swap?

Answer 1

Two parties agree to exchange interest payments on a nominal amount.

Question 2

What is the reset date? When do payments begin?

Answer 2

If an interest rate swap is a fixed vs 6 month floating. The reset date is every 6 months.

At the reset date the interest rate begins to acrue once the rate is known.

Question 3

What is a swaption?

Answer 3

The buyer of a swaption has the right to enter into a swap by an agreed date (effectively the expiry date of an option)

Question 4

What is exchanged in a currency swap?

Answer 4

Principal and Interest

Question 5

What are the 3 cash flows in a currency swap

Answer 5

FX 1 Principal -> FX 2 Principal
Interest Payments
FX 2 Principal -> FX 1 Principal

Question 6

What 4 forms can currency swaps come in?

Answer 6

1) Fixed to Fixed
2) Fixed to Floating
3) Floating to Floating
4) Floating to Fixed

Question 7

What are the uses of currency swaps?

Answer 7

1) Access FX cheaper than in the direct market
2) Hedge existing FX risk from outstanding loans

Question 8

What is exchanged in an equity swap?

Answer 8

1) Party will pay a floating rate (e.g. Libor +2%)
2) Party will pay the gain or loss on an index or equity

Question 9

What happens if the return is negative in an equity return?

Answer 9

The equity receiver will have to pay the loss and the floating rate in the period the loss was recorded.

Question 10

What is a basis swap?

Answer 10

A floating to floating swap where each leg is calculated on a different basis/index

Question 11

What is an asset swap?

Answer 11

Swapping the exposure from an asset.

Usually a bond e.g. FRN -> Fixed Rate

Can also swap FX exposure

Question 12

What does an asset swap allow an investor to do?

Answer 12

Create a synthetic exposure to a security which does not exist.

E.g. want a 10yr Govt FRN but it is only available in fixed

Allows a better choice of asset (e.g. better credit rating - without being constrained by fixed/floating)

Question 13

What is a total return swap?

Answer 13

A modified equity swap.

Works on the same basis but includes all returns - e.g. dividends and interest (and any fees)

Question 14

What are Amortising, Accreting and Rollercoaster Swaps?

Answer 14

1) Amortising - Nominal amount of swap decreases
2) Accreting - Nominal amount of swap increases
3) Rollercoaster - Nominal amount of swap varies (can help to meet cyclical financing needs)

Question 15

What are inflation swaps?

Answer 15

One leg of the swap is an inflation index, e.g. RPI +1%.

The other leg is either

1) Fixed Rate
2) Floating Rate
3) Another Inflation Index (e.g. CPI vs RPI)

Question 16

Why would someone use an inflation swap?

Answer 16

Hedge against price rises (inflation)

Question 17

What is a constant maturity swap?

Answer 17

One leg is fixed or floating

The other leg is reset periodically against a spot on a maturity index.

Question 18

GIve an example of a maturity index

Answer 18

the Federal Reserve maintains yields for treasury issues of various constant maturities.

Question 19

What is the prime factor behind a CMS?

Answer 19

The shape of implied forward rates

Question 20

What is an arrears swap?

Answer 20

In an arrears swap, the period for which payment is due elapses, and then at the end of the period, the rate is observed and retroactively paid.

Question 21

What is a forward start swap?

Answer 21

A forward start swap is one that is agreed today, e.g., the rates to be used and the principal, however, the swap and exchange of funds start later.

For example, a forward start swaps with a 5-year tenor that starts in two years, would expire in 7 years’ time. For the first two years, no payments will be exchanged.

Question 22

What is an overnight index swap?

Answer 22

A fixed for floating swap where the floating index is an overnight interest rate.

1) not paid overnight
2) amount is accumulated and compounded (adjusts for the fact compounding can’t take place)

Question 23

What is a use case of an OIS?

Answer 23

A bank which funds itself overnight but borrows on a longer time horizon.

e.g. borrowing at 1yr and funding overnight - swap the 1yr borrowing for overnight payments to hedge interest and liquidity risk