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Swap
Agreement btwn 2 parties to xchg a series of cash flows at different points in time
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Plain vanilla swap
- Fixed-for-floating swap
- For the floating rate payer, the rate is set at the beginning of each period but the actual pmt is made at the end of the period
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Major use of interest rate swap
Allows efficient mgmt of interest rate sensitivity
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Swap dealer
- Connects one party to the other in a swap transaction
- Assumes credit risk of each party
- Usually charges a fee of a few basis points
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Swap rate
- Fixed rate paid in a plain vanilla swap such that value of fixed & floating are equal to notional principal amt.
- Usually not risk free, but close to because is reflects credit risk of highly rated financial institutions
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Swap spread
Difference btwn swap rate and US Treasury bonds
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Comparative adv argument
- Since different parties may have to pay diff rates to borrow, they could possibly enter a swap to borrow in a more efficient way
- This argument is a bit flawed as the swap mkt is very big and efficient
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2 ways to value a swap
- As an xchg of bonds
- As a series of FRAs
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Other types of swap
- Currency
- Variation of interest (forward, alternative floating, floating-for-floating, amortizing principal, ...)
- Variation in currency (cross currency, quanto, ...)
- Equity swaps
- Options
- Commodity swaps
- Volatility swaps
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