Answers to Questions and Problems
1. Explain the differences between a plain vanilla interest rate swap and a plain vanilla currency swap.
In a plain vanilla interest rate swap, one party pays a fixed rate of interest based on a given nominal amount,
while the second party pays a floating rate of interest based on the same nominal amount. No principal is
exchanged in the agreement. In a plain vanilla foreign currency swap, there are three different sets of cash
flows. First, at the initiation of the swap, the two parties actually do exchange cash. Second, the parties make
periodic interest payments to each other during the life of the swap agreement. In the plain vanilla currency
swap, one party typically pays dollars at a floating rate, and the payer of the nondollar currency pays a fixed
rate. Third, at the termination of the swap, the parties again exchange the principal.
2. Explain the role that the notional principal plays in understanding interest rate swap transactions. Why is
this principal amount regarded as only notional? How does it compare with a deliverable instrument in the
interest rate futures market?
The deliverable instrument in the interest rate futures market is like the notional principal in determining
the scale of the daily settlement cash flows on the futures contracts. For many futures, however, actual deliv-
ery is possible but also avoidable. With an interest rate swap, the notional principal is not ever delivered. If
we think of the Eurodollar futures contract, which is only cash-settled, the analogy between the notional
principal and the underlying $1,000,000 Eurodollar deposit on a futures is quite close.
In interest rate swaps, all of the cash flows are based on a notional amount—notional, because the notional
principal is not actually paid. This is essentially a matter of convenience in helping to conceptualize the
transaction. The entire contract could be stated without regard to the principal amount. One definition of
is “existing in idea only.”
3. Consider a plain vanilla interest rate swap. Explain how the practice of net payments works.
In a typical interest rate swap, each party is scheduled to make payments to the other at certain dates. For the
fixed payer, these amounts are certain, but the payments that the floating payer will have to make are
unknown at the outset of the transaction. In each period, each party will owe a payment to the other. Rather
than make two payments, the party owing the greater amount simply pays the difference between the two
4. Assume that you are a money manager seeking to increase the yield on your portfolio and that you expect
short-term interest rates to rise more than the yield curve would suggest. Would you rather pay a fixed long-
term rate and receive a floating short rate, or the other way around? Explain your reasoning.