Derivatives

CHAPTER 35Other Interest Rate Swaps

Aims

• To price and value ‘non-standard’ interest rate swaps such as variable rate swaps, off-market swaps, zero-coupon swaps, swaps with variable notional principals and basis swaps.
• The swap rate on more complex interest rate swaps can be determined by making the present value of the fixed leg of the swap equal to the (expected) present value of the floating leg (at inception of the swap) – as for plain vanilla swaps. However, the methods used in calculating these present values differ for exotic swaps.
• To show how swap dealers hedge their interest rate swaps book using other fixed income assets such as FRAs, bonds, interest rate futures, and interest rate options.
• To demonstrate how to hedge the credit risk of a swap position using collateral, netting and credit enhancements.

35.1 SWAP DEALS

There are a wide variety of swap contracts which can be designed to suit particular customers' requirements. In a spread-to-LIBOR swap, the floating rate is not at LIBOR-flat but at LIBOR plus a spread. Since most floating-rate bank loans contain a spread over LIBOR, this swap can be constructed to exactly match the floating payments in a LIBOR bank loan. In an off-market swap, the fixed swap rate is set at whatever rate is chosen by the ‘customer’ (e.g. a corporate) – for example, this off-market swap rate might be chosen to exactly match the fixed rate on an existing bank loan. In a zero-coupon swap the fixed payment is not periodic but consists ...