This preview shows pages 1–8. Sign up to view the full content.
1
SWAPS
NBA 673
February 14, 2006
This preview has intentionally blurred sections. Sign up to view the full version.
View Full Document 2
Introduction
A financial
swap
is a contract between 2
counterparties
, to exchange a series of cash
payments. A swap contract specifies:
The [interest rate applicable to] each cash payment;
The currency for each cash payment,;
The payments’ time table;
The provisions to deal with default;
Other relevant issues.
The first swap was negotiated in 1981. The market
is now measured in hundreds billions of dollars of
notional.
3
Basic Scenario for a Swap
Basic scenario for swaps:
A party wants to hedge some risks or transform the
nature of some cash flows.
Goes to a swap dealer (“swap facilitator” or a “swap
bank”) which creates a customized OTC contract to
meet client needs.
The bank then “warehouses the swap”: combines it
with other swaps, uses interest rate derivatives to hedge
residual risk exposure until it finds offsetting swaps.
Huge market size suggests tremendous demand for
swaps. But narrow spreads between receiving and
paying rates reveal intense competition among dealers.
This preview has intentionally blurred sections. Sign up to view the full version.
View Full Document 4
Interest Rate Swap
Consider a simple, generic
(“plain vanilla”)
interest rate swap
.
Counterparties A and B agree on a notional principal
which never changes hands but is used for calculations.
A agrees to make fixed semiannual payments to B, the
size of which is determined by a known fixed rate of
interest on the notional principal.
B agrees to make floating rate payments to A every 6
months, the size of which is based on a semiannual
floating interest rate on the same notional principal.
Payments are made in the same currency. They are
netted and a counterparty pays the difference owed.
5
Example: Plain Vanilla Swap
Swap on a $35 million notional principal.
Party A makes a fixed payment every 6months at
7.19% per annum.
Party B pays LIBOR + 30 basis points
Current 6month LIBOR rate is 6.45% per annum.
This preview has intentionally blurred sections. Sign up to view the full version.
View Full Document 6
Example:
Plain Vanilla Swap (cont’d)
Fixed rate is usually quoted on a semiannual
bond equivalent yield basis.
A pays every 6 months
(Notional Principal)
×
(Days in Period/365)
×
(Interest Rate/100)
= ($35,000,000) (182/365) (0.0719)
= $1,254,802.74.
7
Example:
Plain Vanilla Swap (cont’d)
Floating side is quoted on a money market yield basis.
B pays every 6 months
This preview has intentionally blurred sections. Sign up to view the full version.
View Full Document
This is the end of the preview. Sign up
to
access the rest of the document.
This note was uploaded on 09/28/2008 for the course NBA 6730 taught by Professor Janosi,tibor during the Spring '06 term at Cornell University (Engineering School).
 Spring '06
 JANOSI,TIBOR

Click to edit the document details