Swap Markets and Contracts

Swaps are custom agreements, largely unregulated, not traded in secondary market.   Default risk is important.  Most participants are large institutions - rare for individuals to participate.

Swaps are big business - total notional value of swaps is ~$50 trillion

Plain Vanilla Swap - if I lend you $10,000 at floating rate and you lend me $10,000 at a fixed rate, we have created a swap.  There is no need to actually exchange the $10,000 or even the interest payments, only the differences.

Payments are usually netted except in currency swaps where amounts actually change hands.

Currency Swap - loans are in different currencies at respective rates.  Swap back the same amounts at the end.

Equity swap - have to specify when payments will be made (perhaps it is quarterly, e.g.).  I might promise to make payments equal to the return of a market over the quarter.  If the return is negative, my payment is negative - i.e. you pay me.  Again payments are netted.

Definition: A swap is an agreement to exchange a series of cash flows on period settlement dates over a certain period of time.  Party with greater liability pays the other party.

Length of swap is called TENOR.

Swap can be decomposed into a series of FRAs (forward rate agreements) that expire on the settlement dates

Terminating swaps (4 ways)

• Mutual termination - cash payment by one party that is acceptable to the other party.
• Offsetting contract - lock in the current loss and offset the rest of the contract.  Just like forwards. Will also expose to default risk (again, just like forwards).
• Resale - unusual but it happens.  Sell the swap to another party, with permission of the current counterparty.
• Swaption - this is an option to enter into a swap.  The option to enter into an offsetting swap provides an option to terminate the existing swap.  

Currency Swap

• Might be motivated because an issuer wants to operate in a country but cannot raise debt in that country, and there is a foreign issuer with the exact opposite situation.

Fixed for Fixed Currency Swap

• Notional principal is swapped at initiation
• Interest payments are made WITHOUT netting.  If you got AUD at beginning, you pay interest in AUD.
• At maturity you swap the notional principals again.
• In a swap, each person might borrow from their local bank and then charge the counterparty a higher rate, recording a gain

Interest Rate Swap

• Currency is same usually so principal is not swapped at inception
• Payments are netted - no need to make full payment both ways
• Floating rate is usually LIBOR or LIBOR plus a spread
• (related note - a basis swap involves trading a floating rate for another floating rate)
• No transfer of funds at conclusion, since there was no initial transfer of funds
• SWAPS ARE A ZERO SUM GAME - what one party gains, the other loses
• Formula for fixed rate payer's payment is below:

• Days is days in the swap.  DON'T FORGET TO ADD MARGIN TO LIBOR IF APPLICABLE!!!

Fixed rate payer = the guy with fixed rates who wants to effectively be a floater

Equity Swaps

Return on an equity, portfolio, or index is paid each period by one party in exchange for a fixed OR floating rate payment.  Can be just capital return OR total return (i.e. include dividends).

• Uniquely among swaps - can be floating on both sides, payment not known until end of quarter
• If stock appreciates, holder must give appreciation to the fixed rate payer
• If it goes down, fixed rate payer will give the holder the difference
• Motivation for an equity swap is to protect a large capital gain in a single stock - but you also don't get to participate in any upside - you basically lock in the gain for a certain period

Example