Swaps

Swaps
In a swap, two counterparties agree to exchange or swap cash flows at periodic intervals. An agreement to exchange cash flows at specified future times according to certain specified rules Types of swaps
Interest Rate Swaps Currency Swaps Commodity Swaps Equity Swaps

Interest Rate Swap

Interest rate swap is an exchange of fixed-rate interest payments for floating-rate interest payments.

Typical Uses of an Interest Rate Swap: Converting a liability from fixed rate to floating rate floating rate to fixed rate Converting an investment from fixed rate to floating rate floating rate to fixed rate

Valuation of an Interest Rate Swap

Interest rate swaps can be valued as the difference between the value of a fixed-rate bond and the value of a floating-rate bond Alternatively, they can be valued as a portfolio of forward rate agreements (FRAs)

Valuation in Terms of Bonds

The fixed rate bond is valued in the usual way The floating rate bond is valued by noting that it is worth par immediately after the next payment date

Valuation in Terms of FRAs

Each exchange of payments in an interest rate swap is an FRA The FRAs can be valued on the assumption that todays forward rates are realized

Valuation of an Interest Rate Swap: an Example

Suppose that, under the terms of a swap, a financial institution has agreed to pay six-month LIBOR and receive 8% per annum (with semiannual compounding) on a notional principal of $100 million. The swap has a remaining life of 1.25 years. The LIBOR rates with continuous compounding for 3-month, 9-month and 15-month maturities are 10%, 10.5%, and 11%, respectively. The 6-month LIBOR at the last payment date was 10.2% (with semiannual compounding).

Currency Swaps
Currency swap is an exchange of interest payments in one currency for interest payments in another currency

Example : A bilateral agreement to - Receive 8% on a US$ principal of 15,000,000 - and Pay 11% on a sterling principal of $10,000,000 - cash flows are exchanged every year for 5 years

Principal is exchanged at the beginning and end of the contract

Typical Uses of a Currency Swap

Conversion from a liability in one currency to a liability in another currency Conversion from an investment in one currency to an investment in another currency

Valuation of Currency Swaps

Like interest rate swaps, currency swaps can be valued either as the difference between 2 bonds or as a portfolio of forward contracts

Valuation of a Currency Swap: an Example

Suppose that the term structure of interest rates is flat in both Japan and the US. The Japanese interest rate is 4% per annum and the US rate is 9% per annum (both with continuous compounding). A financial institution has entered into a currency swap in which it receives 5% per annum in yen and pays 8% per annum in dollars once a year. The principals in the two currencies are $10 million and 1,200 million yen. The swap will last for another three years, and the current exchange rate is 110 yen =$1.

Risks of Interest Rate and Currency Swaps

Interest Rate Risk Interest rates might move against the swap bank after it has only gotten half of a swap on the books, or if it has an unhedged position. Basis/Index Risk If the floating rates of the two counterparties are not pegged to the same index. Exchange rate Risk In the example of a currency swap given earlier, the swap bank would be worse off if the pound appreciated

Commodity Swaps
A swap in which exchanged cash flows are dependent on the price of an underlying commodity. A commodity swap is usually used to hedge against the price of a commodity.

EQUITY SWAPS
An equity swap is a special type of total return swap, where the underlying asset is a stock, a basket of stocks, or a stock index. Compared to actually owning the stock, in this case you do not have to pay anything up front, but you do not have any voting or other rights that stock holders do.

Credit default swaps

A credit default swap (CDS) is a swap contract in which the buyer of the CDS makes a series of payments to the seller and, in exchange, receives a payoff if a instrument - typically a bond or loan - goes into default (fails to pay). Less commonly, the credit event that triggers the payoff can be a company undergoing restructuring, bankruptcy or even just having its credit rating downgraded. CDS contracts have been compared with insurance, because the buyer pays a premium and, in return, receives a sum of money if one of the events specified in the contract occur. Unlike an actual insurance contract the buyer is allowed to profit from the contract and may also cover an asset to which the buyer has no direct exposure.