Introduction to Swaps
Swaps are private over the counter agreements that are largely unregulated; swaps can be highly customized to meet the needs of the counterparties.
A swap is a mutually agreed exchange of cash flows.
A swap has an initial value of zero; with the passage of time and change of market conditions, the swap may have negative value for one party and positive value for the other party. The party with positive value is exposed to default risk by the party with negative value.
No money is exchanged at swap initiation, with the exception of currency swaps.
Swaps can be categorized as: currency, interest rate, equity (including equity index), and “commodity & other” swaps.
- Counterparties: The two swap participants
- Notional Principal: Money amount used as part of the calculation in determining the amount of the payment
- Standard (or Plain Vanilla) Interest Rate Swap: One counter party is pay fixed/receive floating and the other counter party is receive fixed/pay floating.
- Term/Tenor/Maturity/Expiration: Length of time over which payment exchanges will take place.
Early Exit of a Swap
A counterparty can make an early exit from a swap contract in one of the following ways:
- Negotiate a termination agreement with the other counterparty. Note that the other counterparty may not be willing to cancel the swap.
- Locate a new counterparty and enter into an economically offsetting swap position with this other counterparty. Note that while the new swap may offset market risk, the party seeking to terminate the initial swap now has counterparty risk exposure to two counterparties.
- Sell the swap to a new party. Note that the original counterparty to the “would be” seller must approve the swap sale. This is a rare exit strategy.
- Purchase a swaption that will enter into a swap that economically offsets the original swap.
- CFA Level 2: Derivatives Part 2 – Introduction
- Introduction to Options
- Synthetic Options and Rationale
- One Period Binomial Option Pricing Model
- Call Option Price Formula
- Binomial Interest Rate Options Pricing
- Black-Scholes-Merton (BSM) Option Pricing Model
- Black-Scholes-Merton Model and the Greeks
- Dynamic Delta Hedging & Gamma Related Issues
- Estimating Volatility for Option Pricing
- Put-Call Parity for Options on Forwards
- Introduction to Swaps
- Plain Vanilla Interest Rate Swap
- Equity Swaps
- Currency Swaps
- Swap Pricing vs. Swap Valuing
- Pricing and Valuing a Plain Vanilla Interest Rate Swap
- Pricing and Valuing Currency Swaps
- Pricing and Valuing Equity Swaps
- Swaps as Theoretical Equivalents of Other Derivatives
- Swaptions and their Valuation
- Swap Credit Risk and Swap Spread
- Interest Rate Derivatives - Caps and Floors
- Credit Default Swaps (CDS)
- Credit Derivative Trading Strategies