1. Swaps
An agreement between two parties to exchange a series of future cash flows.
It’s a series of payments.
At initiation, neither party pays any amount to the other.
It has zero value at the start of the contract.
Except for currency swaps where each party pays each other the notional principal equivalent amounts, but denominated in two different currencies.

2. Swaps Both parties makes payments on settlement dates.
The time between settlement dates is called settlement period.
Netting occurs when the parties agree to exchange only the net amount owed from one party to the other.
The date of final payment of swaps is called the termination date.

3. Swaps Almost exclusively transacted in the over the counter market.
Customized to the parties’ specific needs.

4. Currency Swaps
Each party makes interest payments to the other in different currencies.

5. Types of Currency Swaps
Pay fixed, receive fixed
Pay fixed, received floating
Pay floating, receive floating
Pay floating, receive fixed

6. Interest Rate Swaps
Can be created as a combination of currency swaps.

7. Equity Swaps
A swap in which the rate is the return on a stock or stock index.

8. Types of Equity Swaps
Swap to pay a fixed rate and receive the return on the equity
Swap to pay a floating rate and receive the return on the equity
Swap to pay the return on one equity and receive the return on another

9. Pricing of an Equity Swap
We must determine a combination of stock and bonds that replicates the cash flows on the swap.

10. Plain Vanilla Swap
An interest rate swap where one party pays a fixed rate and the other pays a floating rate, with both sets of payments in the same currency.
Has constant notional principal over life of the swap.
Interest payment on the fixed side is the same dollar amount.
Interest payment on the floating side may vary due to fluctuating interest rates.

11. Flavored Interest Rate Swaps
Amortizing Swaps
Accreting Swaps
Seasonal Swaps
Roller Coaster Swaps
Overnight Index Swaps (OIS)
Arrears Swaps
Off Market Swaps
Rate Differential Swaps or Diff Swaps
Corridor Swaps
Capped Swap
Floored Swap

12. Amortizing Swaps
Notional principal is reduced over time according to a formula related to the underlying.
This means the fixed interest payment becomes smaller during the life of the swap, and the floating payment becomes smaller as well, at least if interest rates are stable.
Since mortgage principal is generally amortized, an amortizing swap provides a useful instrument for managing interest rate risk associated with mortgages.

13. Amortizing Swaps
Also called index amortizing swap where the notional principal is indexed to the level of interest rates.
The notional principal declines with the level of interest rates according to a predefined schedule.
This feature makes the swap similar to mortgage backed securities, which prepay some of their principal as rates fall.
It’s often used to hedge this type of security.

14. Accreting Swaps
Notional principal becomes larger during the life of the swap.
This kind of swap matches the cash flows often encountered in construction finance.
E.g., a 7 year construction project with yearly drawdown of $ 10 million of additional financing (loans) at floating rate.
These flows can be converted to a fixed rate thru accreting swap designed with a principal that increases $ 10 million annually and has a fixed interest rate.

15. Seasonal Swaps Notional principal varies according to a fixed plan.
The variable notional principals increase and decrease over the life of the swap.
Combined features of amortizing and accreting swaps.
Used in matching financing needs of retailers.
E.g., swap could be structured on a seasonal basis to match the typical heavy 4th quarter cash needs of retailing firms.

16. Roller Coaster Swaps
Notional principal on the swap first increases and then amortizes to zero over the life of the swap.
This means the notional principal can be structured to conform to any financing or risk management need.

17. Rate Differential or Diff Swaps
Combines elements of interest rate, currency, and equity swaps.
One party pays the floating interest rate of one country and the other pays the floating interest rate of another country.
Both sets of payments are made in a single currency.
This means one set of payments is based on the interest rate of one country, while the payment is made in the currency of another country.

18. Diff Swaps
It’s a pure play on the interest rate differential between two countries and is basically a currency swap with the currency risk hedged.
In equity diff swaps, the return on a foreign stock index is paid in the domestic curency.

19. Arrears Swap
Special type of interest rate swap where the floating payment is set at the end of the period and the interest is paid at that same time.
This stands in contrast to the typical interest rate sap where the payment is set on one settlement date and the interest is paid on the next settlement date.

20. Capped Swap
Floating payments have a limit as to how high they can be.

21. Floored Swap
Floating payments have a limit as to how low they can be.

22. Overnight Index Swap (OIS)
Commits one party to paying a fixed rate as usual.
The floating rate is the cumulative value of a single unit of currency invested at an overnight rate during the settlement period.
The overnight rate changes daily.
Widely used in Europe, but not in the US.

23. Off Market Swap Coupon payments can vary.
E.g., 5 year swap with annual payments when yield curve is flat at 8%. Fixed payment is at 9%, and floating payment is equal to LIBOR.
Pay fixed pays floating the extra 1%, while floating will pay fixed the PV of the 5 payments of the extra 1% discounted at 8%.

24. Corridor Swaps
Payment obligations occur only when the reference rate is within some specified range or corridor.
Essentially a speculation on the volatility of LIBOR.
E.g., one might enter into the swap to receive a fixed rate & pay 6 month LIBOR only when LIBOR is greater than 5% but less than 7%.

25. Flavored Currency Swaps
Amortizing Swaps
Accreting Swaps
Seasonal Swaps
Roller Coaster Swaps
CIRCUS Swaps

26. CIRCUS Swaps
A fixed for fixed currency swap created by combining a plain vanilla interest rate swap with a plain vanilla currency swap.
Stands for combined interest rate and currency swap.
E.g., a firm enters into a plain vanilla currency swap, while the firm also enters into a plain vanilla interest rate swap to pay-fixed/receive floating.

27. Commodity Swaps
The counterparties make payments based on the price of a specified amount of a commodity, with one party paying a fixed price for the good over the tenor of the swap, while the second party pays a floating price.

28. Forward Swaps Forward contracts that enter into swaps.
Priced by pricing the swap off of the forward term structure instead of the spot term structure.

29. Swaptions An option to enter into a swap. Two types of swaptions:
Payer swaption
Receiver swaption
Have specific expiration dates
Like ordinary options, they can be European style or American style.
It’s based on a specific underlying swap.

30. Payer Swaptions
Allows the holder to enter into a swap as the fixed rate payer and floating rate receiver.
It’s a put option on a bond.

31. Receiver Swaptions
Allows the holder to enter into a swap as the fixed rate receiver and floating rate payer.
It’s a call option on a bond.

32. Example of a Swaption
A European payer swaption that expires in 2 years that allows the holder to enter into 3 year swap with semiannual payments every January 15 and July 15.
The payments will be made at the rate of 6.25% and will be computed using the 30/360 adjustment.
The underlying swap is based on LIBOR.
The notional principal is $ 10 million.

33. Example of a Swaption
It has a price or premium, which is an amount paid by the buyer to the seller up front.
It’s called a 2 x 5 swaption because it expires in 2 years and the underlying expires 3 years after that.
The underlying can be viewed as a 5 year swap at the time the swaption is initiated and will be a 3 year swap when the swaption expires.

34. Uses of Swaptions
Used by parties who anticipate the need for a swap at a later date but would like to establish the fixed rate today, while providing the flexibility to not engage in the swap later or engage in the swap at a more favourable rate in the market.
Used by parties entering into a swap to give them the flexibility to terminate the swap.
Used by parties to speculate on interest rates.

35. Credit Risk of Swaps
Arises due to the possibility that a party will not be able to make its payments.
Current credit risk is the risk of a party being unable to make the upcoming payment.
Potential credit risk is the risk of a party being unable to make future payments.
It’s greatest during the middle of the swap’s life, especially in an interest rate or equity swap.

36. Swap Spread
Difference between the fixed rate on a swap and the yield on a default free security of the same maturity as the swap.
Indicates the average credit risk in the global economy but not the credit risk in a given swap.

37. Netting
Reduces credit risk in a swap by reducing the amount of money passing from any one party to another.
The amount owed by a party is deducted from the amount due to a party, and only the net is paid.

38. Caps
A combination of interest rate call options designed to hedge a borrower against rate increases on a floating rate loan.
Buyer of cap pays the seller of the cap, usually an intermediary or insurance company, a fee up front so that the buyer gets protection from rising interest rates above the strike price (the cap rate) agreed to by both parties.

39. Caps
The cap is intended to ensure the buyer that its interest rate over the life of a loan will not exceed the maximum rate (the cap rate or strike price).

40. Floors
A combination of interest rate put options designed to hedge a lender against lower rates on a floating rate loan.
They provide downside protection on the underlying instrument with an unknown payoff in the future.
They provide insurance that the return will be no less than the minimum rate – floors rate – over the life of the option.

41. Collars
Buying put options, the floors, and simultaneously selling call options, the caps, will creates collars.
An option strategy involving the purchase of a put and sale of a call in which the holder of an asset gains protection below a certain level, the exercise price of a put, and pays for it by giving up gains above a certain level, the exercise price of the call.

42. Collars
They can used to provide protection against rising interest rates on a floating rate loan by giving up gains from lower interest rates.
The motivation for such transaction is to finance some or all of the cost of the purchase of the floors by selling the caps and foregoing the potential of an increase in interest rates that could otherwise improve the performance of the portfolio.

43. Collars
Zero collars are created when the buyer of the collar simultaneously buys and sells floors and caps where the cost of purchasing floors is completely offset by selling the caps.

44. Corridors
It’s a portfolio of two caps where the borrower buys one cap at a certain strike price and simultaneously sells the second cap at a higher strike price to offset some of the cost of the cap purchased.
The borrower that buys the cap and simultaneously sells a cap at a higher strike price (higher rate) believes interest rates will go down in the future.