Fundamentals of Financial Instruments, 2nd Edition

CHAPTER 10Swaps

INTRODUCTION

What exactly is a swap transaction? As the name suggests, it entails the exchanging or 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, all payments are denominated in the same currency. Obviously, the two cash flows being exchanged will be calculated using different interest rates. For instance, one party may compute its payable using a fixed rate of interest, while 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. For instance, the first party may compute its payable based on LIBOR while 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 in practice. For example, consider a deal where Bank ABC agrees to make a payment to the counterparty every six months on a given principal, at the rate of 5.25% per annum in return for a counterpayment based on the same principal that is computed at a rate of 6% per annum. Clearly, 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 ...