Fundamentals of Financial Instruments: An Introduction to Stocks, Bonds, Foreign Exchange, and Derivatives

CHAPTER 10

Swaps

Introduction

What exactly is a swap transaction? As the name suggests, it entails the swapping of cash flows between two counterparties. There are two broad categories of swaps: interest-rate swaps and currency swaps.

In the case of an interest-rate swap (IRS), all payments are denominated in the same currency. The two cash flows being exchanged will be calculated using different interest rates. One party may compute its payable using a fixed rate of interest and the other may calculate what it owes based on a market benchmark such as LIBOR. Such interest-rate swaps are referred to as fixed–floating swaps. A second possibility is that both payments may be based on variable or floating rates. The first party may compute its payable based on LIBOR, whereas the counterparty may calculate what it owes based on the rate for a Treasury security. Such a swap is referred to as a floating–floating swap. It should be obvious to the reader that we cannot have a fixed–fixed swap. Consider a deal in which Bank ABC agrees to make a payment to the counterparty every six months on a given principal at the rate of 5.25 percent per annum in return for a counterpayment based on the same principal computed at a rate of 6 percent per annum. This is an arbitrage opportunity for Bank ABC, because what it owes every period will always be less than what is owed to it. No rational counterparty will therefore agree to be a party to such a contract. In the case of an interest-rate swap, before ...