Derivatives: Valuation and Risk Management

By David A. Dubofsky; Thomas W. Miller Jr. | Go to book overview
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CHAPTER 11

An Introduction to Swaps

Swaps are contractual agreements between two parties to exchange cash flows. The cash flows that are swapped may be determined on the basis of interest rates, exchange rates, or the prices of indexes (such as stock indexes) or commodities. To determine the dollar amounts that will be exchanged these prices are applied to a base amount, called the notional principal of the swap. The two parties that agree to exchange the cash flows are called the counterparties of the swap. One of the counterparties will typically be a swap dealer (market maker); it is rare for two firms to negotiate the terms of a swap contract by themselves.

In this chapter, the basic features of different types of swaps are described. The plain vanilla, fixed-for-floating interest rate swap is covered first, in Section 11.1. A plain vanilla swap is a standard swap with no unusual features. Other interest rate swap structures are briefly covered. Currency swaps are discussed in Section 11.2, and commodity swaps in Section 11.3. Finally, the issue of credit risk in swaps is considered.


11.1 INTEREST RATE SWAPS

The fixed-for-floating fixed-floating interest rate swap is the most basic form of a swap, in which one of the parties agrees to pay (to the other counterparty) a fixed amount of money on specific dates. The fixed payments are expressed as a percentage of the swap's notional principal. For example, 8% of $20 million would create an annual payment of $1.6 million; if semiannual payments are required, the fixed amount would be $800,000 every six months. The notional principal of the swap is not exchanged; it serves only as the basis for calculating the swap payments. The percentage is the fixed interest rate, and it is multiplied by the notional principal to compute the fixed payment. The same party, who is called the fixed-rate payer, also receives a floating, or variable, amount of money on each of the specified dates. The amount to be received is also computed by multiplying a randomly fluctuating interest rate by the swap's notional principal. This floating payment is determined by a floating interest rate that changes over time, such as three-month LIBOR. If this interest rate rises, the fixed-rate payer will receive a greater floating amount of money. If the floating interest rate declines, the fixed-rate payer will receive a smaller floating amount. In practice, the amount received at each date is offset, or netted out, against the amount paid. Thus, if on one particular date, the fixed-rate payer is supposed to pay $1,600,000, and also receive $1,200,000, the net payment made is $400,000 ($1,600,000-$1,200,000=$400,000 outflow). When the counterparties' obligations are netted in this manner, the payment ($400,000) is called a difference check.

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