An interest rate swap is an exchange of cash flows between two parties where party A pays a fixed rate and receives a floating rate and party B receives a fixed rate and pays the floating rate. In essence, party A and party B, known as counterparties, agree to exchange a series of cash flows […]
Swaps
Details of an Interest Rate Swap Contract
An interest rate swap is an exchange of cash flows between two parties where party A pays a fixed rate and receives a floating rate and party B receives a fixed rate and pays the floating rate. An interest rate swap contract has the following characteristics:
Synthetic Relationship Between Swaps and Derivatives
The unifying theory of interest rate risk management rests upon the basis that all hedging instruments (swaps, caps, floors, collars) can be created directly or synthetically from each other. The relationship between option contracts and swap transactions operates at an important level. The Relationship between Option Contracts and Interest Rate Swaps A call option […]
Hedging Using Interest Rate Swaps
In this lesson, we will look at a few examples of how corporations and financial institutions use interest rate swaps. GAP Management This example represents a financial institution, a bank, that is “lengthening the maturity,” “fixing” the interest rate, on its funding base in order to better match the funding costs with the fixed rate […]
What are Foreign Currency Swaps?
Currency swaps are foreign exchange contracts in which two parties agree to exchange the principal and interest of a loan in one currency with the principal and interest of an equivalent loan in another currency. The motive behind a currency swap is to enable each party to gain exposure to another currency at a more […]
What are Basis Swaps?
A basis swap is a type of swap in which two parties exchange the interest payments based on two floating rates. Currency swaps are a type of basis swaps, except that the basis swaps involve only one currency. Similarly, we can say that an interest rate swap with two floating rates is a basis swap. […]
What are Volatility Swaps?
Volatility swaps (also known as variance swaps) are over-the-counter derivatives that used to hedge against the volatility risk of the underlying instruments. The underlying in this case could be foreign exchange rates, interest rates, or stock market indices. The volatility swap will have floating volatility as one leg and fixed volatility as the other leg. […]
Swap Termination
A swap is an agreement between two parties where they agree to exchange the cash flows on different assets for a specified period of time. For example, in a vanilla interest rate swap, two parties agree to exchange the interest obligations on their loans. One party pays interest based on a floating interest rate while […]
Equity Swap Example
In an equity swap, two parties agree to exchange a set of future cash flows periodically for s specified period of time. Once leg of the equity swap is pegged to a floating rate such as LIBOR or is set as a fixed rate. The cash flows on the other leg are linked to the […]