MECHANICS OF INTEREST RATE SWAPS #
The most common interest rate swap is the plain vanilla interest rate swap. In this swap arrangement, Company X agrees to pay Company Y a periodic fixed rate on a notional principal over the tenor of the swap. In return, Company Y agrees to pay Company X a periodic floating rate on the same notional principal. Both payments are in the same currency.
FINANCIAL INTERMEDIARIES #
There are swap intermediaries who bring together parties with needs for the opposite side of a swap. Financial intermediaries, such as banks, will typically earn a spread of about 3 to 4 basis points for bringing two nonfinancial companies together in a swap agreement. This fee is charged to compensate the intermediary for the risk involved. If one of the parties defaults on its swap payments, the intermediary is responsible for making the other party whole.
Confirmations, outline the details of each swap agreement. A representative of each party signs the confirmation, ensuring that they agree with all swap details (such as tenor and fixed/floating rates) and the steps taken in the event of default.
QUOTATIONS FOR T-BILLS #
T-bills and other money-market instruments use a discount rate basis and an actual/360 day count. A T-bill with a $100 face value with n days to maturity and a cash price of Tis quoted as:
T-bill discount rate =(360/n) x (100 — Y)
VALUING INTEREST RATE SWAPS #
THE DISCOUNT RATE
The forward rates implied by either forward rate agreements (FRAs) or the convexity-adjusted Eurodollar futures are used to produce a LIBOR spot curve. The swap cash flows are then discounted using the corresponding spot rate from this curve. The following connection between forward rates and spot rates exists when continuous compounding is used:
Rforward = R2 + (R2 – R1) T1/T2—T1
VALUING AN INTEREST RATE SWAP WITH BONDS
Valuing an interest rate swap in terms of bond positions involves understanding that the value of a floating rate bond will be equal to the notional amount at any of its periodic settlement dates when the next payment is set to the market (floating) rate. Since Vswap = Bondfixed — Bondfloating, we can value the fixed-rate bond using the spot rate curve and then discount the next (known) floating-rate payment plus the notional amount at the current discount rate.
VALUING AN INTEREST RATE SWAP WITH FRAs
Aan interest rate swap is equivalent to a series of FRAs. One way to value a swap would be to use expected forward rates to forecast the expected net cash flows and then discount these expected cash flows at the corresponding spot rates, consistent with forward rate expectations.
CURRENCY SWAPS #
A currency swap exchanges both principal and interest rate payments with payments in different currencies. The exchange rate used in currency swaps is the spot exchange rate. The valuation and application of currency swaps is similar to the interest rate swap.
USING CURRENCY SWAP TO TRANSFORM EXISTING POSITIONS
Currency swaps can be combined with existing positions to completely alter the risk of a liability or an asset.
Comparative advantage is also used to explain the success of currency swaps. Typically, a domestic borrower will have an easier time borrowing in his own currency. This often results in comparative advantages that can be exploited by using a currency swap. The argument is directly analogous to that used for interest rate swaps.
SWAP CREDIT RISK #
Because Vswap (A) + Vswap(B) = 0, whenever one side of a swap has a positive value, the other side must be negative. For example, if Vswap (A) > 0, Vswap (B) < 0. As Vswap(A) increases in value, Vswap(B) must become more negative. This results in increased credit risk to A since the likelihood of default increases as B has larger and larger payments to make to A. However, the potential losses in swaps are generally much smaller than the potential losses from defaults on debt with the same principal. This is because the value of swaps is generally much smaller than the value of the debt.
LIMITATIONS OF DURATION #
- Equity swap: In an equity swap, the return on a stock, a portfolio, or a stock index is paid each period by one party in return for a fixed-rate or floating-rate payment. The return can be the capital appreciation or the total return including dividends on the stock, portfolio, or index.
- Swaption: A swaption is an option which gives the holder the right to enter into an interest rate swap. Swaptions can be American- or European-style options. Like any option, a swaption is purchased for a premium that depends on the strike rate (the fixed rate) specified in the swaption.
- Commodity Swap: Firms may enter into commodity swap agreements where they agree to pay a fixed rate for the multi-period delivery of a commodity and receive a corresponding floating rate based on the average commodity spot rates at the time of delivery.
- Volatility Swap: A volatility swap involves the exchanging of volatility based on a notional principal. One side of the swap pays based on a pre-specified volatility while the other side pays based on historical volatility.