SwapsSwaps

An agreement between two parties to exchange a An agreement between two parties to exchange a series of future cash flows.series of future cash flows.

It’s a series of payments.It’s a series of payments. At initiation, neither party pays any amount to the At initiation, neither party pays any amount to the

other.other. It has zero value at the start of the contract.It has zero value at the start of the contract. Except for currency swaps where each party pays Except for currency swaps where each party pays

each other the notional principal equivalent amounts, each other the notional principal equivalent amounts, but denominated in two different currencies.but denominated in two different currencies.

SwapsSwaps

Both parties makes payments on settlement Both parties makes payments on settlement dates.dates.

The time between settlement dates is called The time between settlement dates is called settlement period.settlement period.

Netting occurs when the parties agree to Netting occurs when the parties agree to exchange only the net amount owed from one exchange only the net amount owed from one party to the other.party to the other.

The date of final payment of swaps is called The date of final payment of swaps is called the termination date.the termination date.

SwapsSwaps

Almost exclusively transacted in the over the Almost exclusively transacted in the over the counter market.counter market.

Customized to the parties’ specific needs. Customized to the parties’ specific needs.

Currency SwapsCurrency Swaps

Each party makes interest payments to the Each party makes interest payments to the other in different currencies.other in different currencies.

Types of Currency SwapsTypes of Currency Swaps

Pay fixed, receive fixedPay fixed, receive fixed Pay fixed, received floatingPay fixed, received floating Pay floating, receive floatingPay floating, receive floating Pay floating, receive fixedPay floating, receive fixed

Interest Rate SwapsInterest Rate Swaps

Can be created as a combination of currency Can be created as a combination of currency swaps.swaps.

Equity SwapsEquity Swaps

A swap in which the rate is the return on a A swap in which the rate is the return on a stock or stock index.stock or stock index.

Types of Equity SwapsTypes of Equity Swaps

Swap to pay a fixed rate and receive the return Swap to pay a fixed rate and receive the return on the equityon the equity

Swap to pay a floating rate and receive the Swap to pay a floating rate and receive the return on the equityreturn on the equity

Swap to pay the return on one equity and Swap to pay the return on one equity and receive the return on anotherreceive the return on another

Pricing of an Equity SwapPricing of an Equity Swap

We must determine a combination of stock We must determine a combination of stock and bonds that replicates the cash flows on the and bonds that replicates the cash flows on the swap.swap.

Plain Vanilla SwapPlain Vanilla Swap

An interest rate swap where one party pays a An interest rate swap where one party pays a fixed rate and the other pays a floating rate, fixed rate and the other pays a floating rate, with both sets of payments in the same with both sets of payments in the same currency.currency.

Has constant notional principal over life of the Has constant notional principal over life of the swap.swap.

Interest payment on the fixed side is the same Interest payment on the fixed side is the same dollar amount.dollar amount.

Interest payment on the floating side may vary Interest payment on the floating side may vary due to fluctuating interest rates.due to fluctuating interest rates.

Flavored Interest Rate Swaps Flavored Interest Rate Swaps Amortizing SwapsAmortizing Swaps Accreting SwapsAccreting Swaps Seasonal SwapsSeasonal Swaps Roller Coaster SwapsRoller Coaster Swaps Overnight Index Swaps (OIS)Overnight Index Swaps (OIS) Arrears SwapsArrears Swaps Off Market SwapsOff Market Swaps Rate Differential Swaps or Diff SwapsRate Differential Swaps or Diff Swaps Corridor SwapsCorridor Swaps Capped SwapCapped Swap Floored SwapFloored Swap

Amortizing SwapsAmortizing Swaps Notional principal is reduced over time Notional principal is reduced over time

according to a formula related to the according to a formula related to the underlying.underlying.

This means the fixed interest payment This means the fixed interest payment becomes smaller during the life of the swap, becomes smaller during the life of the swap, and the floating payment becomes smaller as and the floating payment becomes smaller as well, at least if interest rates are stable.well, at least if interest rates are stable.

Since mortgage principal is generally Since mortgage principal is generally amortized, an amortizing swap provides a amortized, an amortizing swap provides a useful instrument for managing interest rate useful instrument for managing interest rate risk associated with mortgages.risk associated with mortgages.

Amortizing SwapsAmortizing Swaps

Also called index amortizing swap where the Also called index amortizing swap where the notional principal is indexed to the level of notional principal is indexed to the level of interest rates. interest rates.

The notional principal declines with the level The notional principal declines with the level of interest rates according to a predefined of interest rates according to a predefined schedule.schedule.

This feature makes the swap similar to This feature makes the swap similar to mortgage backed securities, which prepay mortgage backed securities, which prepay some of their principal as rates fall.some of their principal as rates fall.

It’s often used to hedge this type of security.It’s often used to hedge this type of security.

Accreting SwapsAccreting Swaps Notional principal becomes larger during the Notional principal becomes larger during the

life of the swap.life of the swap. This kind of swap matches the cash flows This kind of swap matches the cash flows

often encountered in construction finance.often encountered in construction finance. E.g., a 7 year construction project with yearly E.g., a 7 year construction project with yearly

drawdown of $ 10 million of additional drawdown of $ 10 million of additional financing (loans) at floating rate.financing (loans) at floating rate.

These flows can be converted to a fixed rate These flows can be converted to a fixed rate thru accreting swap designed with a principal thru accreting swap designed with a principal that increases $ 10 million annually and has a that increases $ 10 million annually and has a fixed interest rate.fixed interest rate.

Seasonal SwapsSeasonal Swaps Notional principal varies according to a fixed Notional principal varies according to a fixed

plan.plan. The variable notional principals increase and The variable notional principals increase and

decrease over the life of the swap.decrease over the life of the swap. Combined features of amortizing and accreting Combined features of amortizing and accreting

swaps.swaps. Used in matching financing needs of retailers.Used in matching financing needs of retailers. E.g., swap could be structured on a seasonal E.g., swap could be structured on a seasonal

basis to match the typical heavy 4basis to match the typical heavy 4 thth quarter quarter cash needs of retailing firms.cash needs of retailing firms.

Roller Coaster SwapsRoller Coaster Swaps

Notional principal on the swap first increases Notional principal on the swap first increases and then amortizes to zero over the life of the and then amortizes to zero over the life of the swap.swap.

This means the notional principal can be This means the notional principal can be structured to conform to any financing or risk structured to conform to any financing or risk management need.management need.

Rate Differential or Diff SwapsRate Differential or Diff Swaps Combines elements of interest rate, currency, Combines elements of interest rate, currency,

and equity swaps.and equity swaps. One party pays the floating interest rate of one One party pays the floating interest rate of one

country and the other pays the floating interest country and the other pays the floating interest rate of another country. rate of another country.

Both sets of payments are made in a single Both sets of payments are made in a single currency.currency.

This means one set of payments is based on This means one set of payments is based on the interest rate of one country, while the the interest rate of one country, while the payment is made in the currency of another payment is made in the currency of another country.country.

Diff SwapsDiff Swaps

It’s a pure play on the interest rate differential It’s a pure play on the interest rate differential between two countries and is basically a between two countries and is basically a currency swap with the currency risk hedged.currency swap with the currency risk hedged.

In equity diff swaps, the return on a foreign In equity diff swaps, the return on a foreign stock index is paid in the domestic curency.stock index is paid in the domestic curency.

Arrears SwapArrears Swap Special type of interest rate swap where the Special type of interest rate swap where the

floating payment is set at the end of the period floating payment is set at the end of the period and the interest is paid at that same time.and the interest is paid at that same time.

This stands in contrast to the typical interest This stands in contrast to the typical interest rate sap where the payment is set on one rate sap where the payment is set on one settlement date and the interest is paid on the settlement date and the interest is paid on the next settlement date.next settlement date.

Capped SwapCapped Swap

Floating payments have a limit as to how high Floating payments have a limit as to how high they can be.they can be.

Floored SwapFloored Swap

Floating payments have a limit as to how low Floating payments have a limit as to how low they can be.they can be.

Overnight Index Swap (OIS)Overnight Index Swap (OIS)

Commits one party to paying a fixed rate as Commits one party to paying a fixed rate as usual.usual.

The floating rate is the cumulative value of a The floating rate is the cumulative value of a single unit of currency invested at an overnight single unit of currency invested at an overnight rate during the settlement period.rate during the settlement period.

The overnight rate changes daily.The overnight rate changes daily. Widely used in Europe, but not in the US.Widely used in Europe, but not in the US.

Off Market SwapOff Market Swap

Coupon payments can vary.Coupon payments can vary. E.g., 5 year swap with annual payments when E.g., 5 year swap with annual payments when

yield curve is flat at 8%. Fixed payment is at yield curve is flat at 8%. Fixed payment is at 9%, and floating payment is equal to LIBOR.9%, and floating payment is equal to LIBOR.

Pay fixed pays floating the extra 1%, while Pay fixed pays floating the extra 1%, while floating will pay fixed the PV of the 5 floating will pay fixed the PV of the 5 payments of the extra 1% discounted at 8%.payments of the extra 1% discounted at 8%.

Corridor SwapsCorridor Swaps

Payment obligations occur only when the Payment obligations occur only when the reference rate is within some specified range reference rate is within some specified range or corridor.or corridor.

Essentially a speculation on the volatility of Essentially a speculation on the volatility of LIBOR.LIBOR.

E.g., one might enter into the swap to receive a E.g., one might enter into the swap to receive a fixed rate & pay 6 month LIBOR only when fixed rate & pay 6 month LIBOR only when LIBOR is greater than 5% but less than 7%.LIBOR is greater than 5% but less than 7%.

Flavored Currency SwapsFlavored Currency Swaps

Amortizing SwapsAmortizing Swaps Accreting SwapsAccreting Swaps Seasonal SwapsSeasonal Swaps Roller Coaster SwapsRoller Coaster Swaps CIRCUS SwapsCIRCUS Swaps

CIRCUS SwapsCIRCUS Swaps

A fixed for fixed currency swap created by A fixed for fixed currency swap created by combining a plain vanilla interest rate swap combining a plain vanilla interest rate swap with a plain vanilla currency swap.with a plain vanilla currency swap.

Stands for combined interest rate and currency Stands for combined interest rate and currency swap.swap.

E.g., a firm enters into a plain vanilla currency E.g., a firm enters into a plain vanilla currency swap, while the firm also enters into a plain swap, while the firm also enters into a plain vanilla interest rate swap to pay-fixed/receive vanilla interest rate swap to pay-fixed/receive floating.floating.

Commodity SwapsCommodity Swaps

The counterparties make payments based on The counterparties make payments based on the price of a specified amount of a the price of a specified amount of a commodity, with one party paying a fixed commodity, with one party paying a fixed price for the good over the tenor of the swap, price for the good over the tenor of the swap, while the second party pays a floating price.while the second party pays a floating price.

Forward SwapsForward Swaps

Forward contracts that enter into swaps.Forward contracts that enter into swaps. Priced by pricing the swap off of the forward Priced by pricing the swap off of the forward

term structure instead of the spot term term structure instead of the spot term structure.structure.

SwaptionsSwaptions

An option to enter into a swap.An option to enter into a swap. Two types of swaptions:Two types of swaptions:1.1. Payer swaptionPayer swaption2.2. Receiver swaptionReceiver swaption Have specific expiration datesHave specific expiration dates Like ordinary options, they can be European Like ordinary options, they can be European

style or American style.style or American style. It’s based on a specific underlying swap.It’s based on a specific underlying swap.

Payer SwaptionsPayer Swaptions

Allows the holder to enter into a swap as the Allows the holder to enter into a swap as the fixed rate payer and floating rate receiver.fixed rate payer and floating rate receiver.

It’s a put option on a bond.It’s a put option on a bond.

Receiver SwaptionsReceiver Swaptions

Allows the holder to enter into a swap as the Allows the holder to enter into a swap as the fixed rate receiver and floating rate payer.fixed rate receiver and floating rate payer.

It’s a call option on a bond.It’s a call option on a bond.

Example of a SwaptionExample of a Swaption A European payer swaption that expires in 2 A European payer swaption that expires in 2

years that allows the holder to enter into 3 year years that allows the holder to enter into 3 year swap with semiannual payments every January swap with semiannual payments every January 15 and July 15.15 and July 15.

The payments will be made at the rate of The payments will be made at the rate of 6.25% and will be computed using the 30/360 6.25% and will be computed using the 30/360 adjustment.adjustment.

The underlying swap is based on LIBOR.The underlying swap is based on LIBOR. The notional principal is $ 10 million.The notional principal is $ 10 million.

Example of a SwaptionExample of a Swaption

It has a price or premium, which is an amount It has a price or premium, which is an amount paid by the buyer to the seller up front.paid by the buyer to the seller up front.

It’s called a 2 x 5 swaption because it expires It’s called a 2 x 5 swaption because it expires in 2 years and the underlying expires 3 years in 2 years and the underlying expires 3 years after that.after that.

The underlying can be viewed as a 5 year The underlying can be viewed as a 5 year swap at the time the swaption is initiated and swap at the time the swaption is initiated and will be a 3 year swap when the swaption will be a 3 year swap when the swaption expires.expires.

Uses of SwaptionsUses of Swaptions

Used by parties who anticipate the need for a Used by parties who anticipate the need for a swap at a later date but would like to establish swap at a later date but would like to establish the fixed rate today, while providing the the fixed rate today, while providing the flexibility to not engage in the swap later or flexibility to not engage in the swap later or engage in the swap at a more favourable rate engage in the swap at a more favourable rate in the market.in the market.

Used by parties entering into a swap to give Used by parties entering into a swap to give them the flexibility to terminate the swap. them the flexibility to terminate the swap.

Used by parties to speculate on interest rates.Used by parties to speculate on interest rates.

Credit Risk of SwapsCredit Risk of Swaps

Arises due to the possibility that a party will Arises due to the possibility that a party will not be able to make its payments.not be able to make its payments.

Current credit risk is the risk of a party being Current credit risk is the risk of a party being unable to make the upcoming payment.unable to make the upcoming payment.

Potential credit risk is the risk of a party being Potential credit risk is the risk of a party being unable to make future payments.unable to make future payments.

It’s greatest during the middle of the swap’s It’s greatest during the middle of the swap’s life, especially in an interest rate or equity life, especially in an interest rate or equity swap.swap.

Swap SpreadSwap Spread

Difference between the fixed rate on a swap Difference between the fixed rate on a swap and the yield on a default free security of the and the yield on a default free security of the same maturity as the swap.same maturity as the swap.

Indicates the average credit risk in the global Indicates the average credit risk in the global economy but not the credit risk in a given economy but not the credit risk in a given swap.swap.

NettingNetting

Reduces credit risk in a swap by reducing the Reduces credit risk in a swap by reducing the amount of money passing from any one party amount of money passing from any one party to another.to another.

The amount owed by a party is deducted from The amount owed by a party is deducted from the amount due to a party, and only the net is the amount due to a party, and only the net is paid.paid.

CapsCaps

A combination of interest rate call options A combination of interest rate call options designed to hedge a borrower against rate designed to hedge a borrower against rate increases on a floating rate loan.increases on a floating rate loan.

Buyer of cap pays the seller of the cap, usually Buyer of cap pays the seller of the cap, usually an intermediary or insurance company, a fee an intermediary or insurance company, a fee up front so that the buyer gets protection from up front so that the buyer gets protection from rising interest rates above the strike price (the rising interest rates above the strike price (the cap rate) agreed to by both parties.cap rate) agreed to by both parties.

CapsCaps

The cap is intended to ensure the buyer that its The cap is intended to ensure the buyer that its interest rate over the life of a loan will not interest rate over the life of a loan will not exceed the maximum rate (the cap rate or exceed the maximum rate (the cap rate or strike price).strike price).

FloorsFloors

A combination of interest rate put options A combination of interest rate put options designed to hedge a lender against lower rates designed to hedge a lender against lower rates on a floating rate loan.on a floating rate loan.

They provide downside protection on the They provide downside protection on the underlying instrument with an unknown underlying instrument with an unknown payoff in the future.payoff in the future.

They provide insurance that the return will be They provide insurance that the return will be no less than the minimum rate – floors rate – no less than the minimum rate – floors rate – over the life of the option.over the life of the option.

CollarsCollars

Buying put options, the floors, and Buying put options, the floors, and simultaneously selling call options, the caps, simultaneously selling call options, the caps, will creates collars.will creates collars.

An option strategy involving the purchase of a An option strategy involving the purchase of a put and sale of a call in which the holder of an put and sale of a call in which the holder of an asset gains protection below a certain level, the asset gains protection below a certain level, the exercise price of a put, and pays for it by exercise price of a put, and pays for it by giving up gains above a certain level, the giving up gains above a certain level, the exercise price of the call.exercise price of the call.

CollarsCollars

They can used to provide protection against They can used to provide protection against rising interest rates on a floating rate loan by rising interest rates on a floating rate loan by giving up gains from lower interest rates.giving up gains from lower interest rates.

The motivation for such transaction is to The motivation for such transaction is to finance some or all of the cost of the purchase finance some or all of the cost of the purchase of the floors by selling the caps and foregoing of the floors by selling the caps and foregoing the potential of an increase in interest rates that the potential of an increase in interest rates that could otherwise improve the performance of could otherwise improve the performance of the portfolio.the portfolio.

CollarsCollars

Zero collars are created when the buyer of the Zero collars are created when the buyer of the collar simultaneously buys and sells floors and collar simultaneously buys and sells floors and caps where the cost of purchasing floors is caps where the cost of purchasing floors is completely offset by selling the caps.completely offset by selling the caps.

CorridorsCorridors

It’s a portfolio of two caps where the borrower It’s a portfolio of two caps where the borrower buys one cap at a certain strike price and buys one cap at a certain strike price and simultaneously sells the second cap at a higher simultaneously sells the second cap at a higher strike price to offset some of the cost of the strike price to offset some of the cost of the cap purchased.cap purchased.

The borrower that buys the cap and The borrower that buys the cap and simultaneously sells a cap at a higher strike simultaneously sells a cap at a higher strike price (higher rate) believes interest rates will price (higher rate) believes interest rates will go down in the future.go down in the future.