MBA Sem – 4

Derivatives Unit – 5
Swap Contract
A swap contract, in finance, is an agreement between two parties to
exchange cash flows or liabilities from two different financial
instruments. These contracts are commonly used for risk management,
speculation, or restructuring debt obligations.

They are used for various reasons, including:

• Risk management: Swaps can help businesses hedge against
fluctuations in interest rates, currency exchange rates, or
commodity prices.
• Speculation: Some investors use swaps to bet on the future
direction of markets.
• Debt restructuring: Swaps can allow companies to change the
terms of their debt obligations, such as converting from a fixed-
rate loan to a variable-rate loan.

• Types of Swaps
• Interest rate swaps: One party might exchange fixed interest
payments for variable interest payments.
• Currency swaps: One party might exchange principal and interest
payments in one currency for those in another currency.
• Commodity swaps: One party might exchange cash flows based
on the price of a commodity, like oil or gold, with another party.

• Key components:
• Notional principal amount: The underlying value that the cash
flows are based on.
• Payment terms: The frequency and timing of the cash flow
exchanges.
• Swap duration: The length of time the contract is in effect.

Structure of Swap Dealings for Risk Management

Basic Swap Structure

• Two Counterparties
 • Two Legs of the Swap:
o Fixed leg: Pays a predetermined interest rate
o Floating leg: Pays an interest rate that varies with an index (e.g.,
LIBOR, SOFR)
• Notional Principal: Basis for calculation, not exchanged
• Tenor: Duration of the swap
• Settlement Frequency: e.g., Semi-annually or quarterly
• Effective and Maturity Dates: Start and end of swap period

Execution and Settlement

• Negotiated and customized via dealers or inter-dealer brokers.

• Cash flows are settled on net basis (netting of fixed and floating
amounts).

Use in Risk Management

• Hedging interest rate and currency exposures.

• Matching assets and liabilities.
• Transforming the nature of cash flows (e.g., fixed to floating).

Interest Rate Swap

An Interest Rate Swap (IRS) is a financial contract where two parties agree
to exchange interest payments on a notional principal amount over a
specific period. It's a way to manage interest rate risk or speculate on future
rate movements.

• Types:
• Fixed to Floating: One party pays a fixed interest rate, and the
other pays a floating rate based on a benchmark like LIBOR or
SOFR.
Floating to Floating: Two parties exchange interest payments
•
based on two different floating rates.
• Mechanism:
 • Notional Principal: The underlying amount on which interest
payments are calculated. This principal is not actually exchanged,
only the interest payments are.
• Cash Flow Exchange: Parties exchange interest payments at
regular intervals based on the agreed-upon rates.
• Hedging: Companies might use IRSs to convert floating-rate debt
into fixed-rate debt or vice versa to stabilize cash flows.
• Examples:
• Hedge against rising interest rates: A company with a floating-
rate loan might use an IRS to convert it to a fixed rate to protect
against rate increases.
• Speculate on interest rate movements: An investor might enter
into a swap to bet on future rate movements.
• Risks:
• Counterparty Risk: If one party defaults, the other might not be
able to receive their agreed-upon payments.
• Basis Risk: The risk that the benchmark used for the floating rate
may not fully reflect the actual interest rate environment.
• Liquidity Risk: Difficulty in unwinding or terminating the swap if
needed

Swaption

A swaption (also known as a swap option) is an option contract that grants

its holder the right but not the obligation to enter into a predetermined swap
contract. In return for the right, the holder of the swaption must pay a
premium to the issuer of the contract. Swaptions typically provide the rights
to enter into interest rate swaps, but swaptions with other types of swaps
can also be created.

In terms of their trading characteristics, swaptions are closer to swaps than

to options. For example, swaptions are over-the-counter securities similar to
swaps. In other words, the derivative contracts are traded over-the-counter,
not on centralized exchanges. Also, the swaptions benefit from a great
degree of flexibility since the contracts do not come in a standardized form.

Before the transaction, the counterparties in a swaption must agree on the

various features of the contract. For example, the parties determine the
price of the swaption (also known as the swaption’s premium) and the
length of the option.
In addition, the counterparties must decide on the features of the underlying
swap. The features generally include the notional amount, swap’s legs (fixed
vs. float), and frequency of adjustment for the variable leg. Also, the
counterparties determine the benchmark for the floating leg of a swap.

Applications of Swaptions

Swaptions come with numerous applications in the investment industry. For

example, they are frequently used in hedging various macroeconomic risks
such as interest rate risk. A company anticipating an interest rate increase
may purchase a payer swaption to protect itself from the interest rate risk.
Additionally, the swaption may allow hedging the risks associated with
financial securities such as bonds. Also, financial institutions commonly
employ swaptions to change their payoff profile.

Swaptions are primarily employed by large corporations and financial

institutions, including investment banks, commercial banks, and hedge
funds.

Types of Swaptions

The classification of swaptions is based on the types of legs involved in the

anticipating swap contract. Based on such a classification, there are two
primary types of swaption: payer swaption and receiver swaption.

With the purchase of a payer swaption, the purchaser obtains the right to
enter into a swap contract, which implies that he or she receives the floating
swap leg in exchange for the fixed swap leg.

Conversely, the receiver swaption delivers the right but not an obligation to
enter into a swap contract, in which the holder of a swap must pay the
floating swap in exchange for the fixed swap leg.

Currency Swaps
Definition

Swap agreement to exchange principal and interest payments in different

currencies.

Types

• Fixed-for-Fixed: Both legs pay fixed interest in different currencies.

• Fixed-for-Floating: One leg fixed, other floating.
• Floating-for-Floating: Both legs floating in different currencies.

Applications

• Hedging foreign exchange and interest rate risk simultaneously.

• Accessing cheaper financing in foreign markets.

Structure

• Initial exchange of principal in each currency.

• Periodic interest payments.
• Final re-exchange of principal at maturity.

Valuation

• Cash flows in each currency are discounted using local discount

curves.
• Convert one leg using current spot FX rates to calculate net value.

Valuation and Pricing of Swaps

General Principles

• Swaps are priced at initiation so that their net present value (NPV) =
0.
• Value = Present Value (PV) of one leg – PV of the other leg.

Interest Rate Swaps

• Fixed leg: PV of fixed rate payments.

• Floating leg: PV of expected floating rate payments (from forward
rates).

Currency Swaps

• Discount each leg in its respective currency.

• Convert using spot exchange rate.
Swaptions

• Option models required (Black, Hull-White).

• Incorporate volatility and term structure of interest rates.

Risk Management Function of Swap Transactions

A. Hedging

• Manage exposure to:

o Interest rate fluctuations
o Exchange rate volatility
o Credit events

B. Asset-Liability Management (ALM)

• Align cash flows of assets and liabilities to stabilize income.

C. Yield Enhancement

• Modify the return profile without altering underlying exposure.

D. Customization

• Meet specific risk preferences and exposure profiles.

Credit Default Swaps (CDS)

• A credit default swap (CDS) is a type of derivative that transfers the

credit exposure of fixed-income products.
• In a credit default swap contract, the buyer pays an ongoing premium
similar to the payments on an insurance policy. In exchange, the
seller agrees to pay the security’s value and interest payments if a
default occurs.
• In 2023, the estimated size of the U.S. CDS market was over $4.3
trillion.
• Credit default swaps can be used for speculation, hedging, or as a
form of arbitrage.
• Credit default swaps played a role in both the 2008 Great Recession
and the 2010 European Sovereign Debt Crisis.

Credit Default Swaps and Credit Events

The credit event is a trigger that causes the CDS buyer to settle the
contract. Credit events are agreed upon when the CDS is purchased and
are part of the contract. The majority of single-name CDSs are traded with
the following credit events as triggers:

• Reference entity default other than failure to pay: An event where the
issuing entity defaults for a reason that is not a failure to pay
• Failure to pay: The reference entity fails to make payments
• Obligation acceleration: When contract obligations are moved, such
as when the issuer needs to pay debts earlier than anticipated
• Repudiation: A dispute in the contract validity
• Moratorium: A suspension of the contract until the issues that led to
the suspension are resolved
• Obligation restructuring: When the underlying loans are restructured
• Government intervention: Actions taken by the government that affect
the contract