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Unformatted text preview: Version: January 3, 2011 FIN 7400: Financial Risk Management Unit IIC Notes Page 1 of 23 D. M. Chance, LSU II. TOOLS AND APPLICATIONS OF MARKET RISK MANAGEMENT C. Swap Contracting Characteristics of Swaps Let us start with the definition of a swap: A swap is a transaction between two parties in which each party agrees to pay the other a series of cash flows at specific dates over a specific period of time. At least one set of cash flows is based on the outcome of a random factor, such as an interest rate, exchange rate, stock price, or commodity price. The other set of cash flows can be random or fixed. In this course our primary focus is on interest rate and currency swaps. Although interest rate swaps are far more widely used, currency swaps came first and can be viewed as more general instruments than interest rate swaps. A currency swap is an agreement between two parties for each party to pay the other a series of cash flows in different currencies. One party pays in one currency and the other in another currency. The cash flows are in the form of interest payments and many currency swaps can include principal payments. Each set of interest payments can be at a fixed or floating rate. Similarly, An interest rate swap is an agreement between two parties for each party to make to the other a series of interest payments. The payments are made in the same currency. At least one set of payments is at a floating rate, while the other can be at a floating or fixed rate. The principal payments are never exchanged. In both types of swaps, the payments are calculated based on a specific amount of principal, which is called the notional principal . All swaps have a specific start date, scheduled payment dates (called settlement dates), and a date on which the payments end (called the termination or expiration date). The periods between payment dates are called settlement periods. Swaps are created in over-the-counter markets and, therefore, are subject to credit risk. Swaps are typically designed to be held to their termination dates, but in many cases, parties change their minds as to whether they want to continue with the swap. In most cases, the party would go back to the counterparty and offer to settle the market value in cash. We shall learn how to calculate the market value later. Alternatively, the party could enter into a swap with another party, with the cash flows opposite to the original Version: January 3, 2011 FIN 7400: Financial Risk Management Unit IIC Notes Page 2 of 23 D. M. Chance, LSU swap. For example, say you enter into a swap with counterparty A to pay LIBOR and receive a fixed rate of F with counterparty A. To offset that swap, you enter a new swap with counterparty B to receive LIBOR and pay a fixed rate of G. Your cash flows are On the first swap with counterparty A: P a y L I B O R Receive fixed rate of F On the second swap with counterparty B: Pay fixed rate of G Receive LIBOR The LIBORs offset but do not cancel. All payments still have to be made, but the next...
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This note was uploaded on 02/28/2012 for the course FIN 7400 taught by Professor Donchance during the Fall '11 term at LSU.
- Fall '11