Swap Contracts

Swaps Swap: An agreement between two parties (“counterparties) to exchange a series of cash flows in the future –Essentially a series of forwards –Settle at each swap maturity date (often netted out) –Payments generally determined so swap initially has zero market value Common are –Interest rate swaps –Currency swaps

Swaps vs. Futures Futures –Standardized –Exchange-traded –Short horizons Swaps –Custom tailored between counterparties –Less regulation; potential for privacy –Term flexibility

Interest Rate Swaps One party pays a fixed interest rate and receives a floating rate The other party pays a floating rate and receives a fixed rate Floating rates involve greater exposure to interest rate risk “Notional principal” is amount on which the interest payments are determined

Interest Rate Swaps (cont.) Principal is not actually exchanged -- only interest payments Often, only net interest payments are transacted –Avoids unnecessary transactions –Helps credit risk At each “settlement date,” a net payment is made, based on the difference between the two interest rates (applied to the notional principal)

Types of Swaps Swap curve –Swap rates for different maturities –Analogous to yield curve Deferred swap –Begins in future Amortizing swap –Covers loan with declining balance Accreting swap –Covers loan with increasing balance

Q: Swaps – Fixed rate Calculation (From Exam FM Fin Econ Sample Questions)

Q: Swaps – Cash Flow Calculation (From Exam FM Fin Econ Sample Questions)