Islamic Capital Markets: Theory and Practice

Chapter 12

Swaps

The purpose of this chapter is to study swaps and their applications in risk management. The chapter describes the structure and payoff of a swap; the motivations for the swap; and the valuation of plain-vanilla swaps. The chapter discusses currency swaps; the motivation for currency swaps; their benefits and drawbacks; and their pricing. In the same vein, the chapter addresses many innovations in swaps; it analyzes the structure and the pricing of equity swaps, credit default swap, and total return swaps. The chapter illustrates how swaps are used in structured finance to design structured notes such as inverse floaters and bear floaters. The chapter discusses options on interest rate swaps, called swaptions; it shows how European swaptions are priced. Finally, the chapter treats the role of interest rate swaps as hedging instruments. It analyzes the duration of a swap; interest rate immunization with swaps; duration gap hedging; and setting interest rate sensitivity with swaps.

A swap is another method for reducing financial risks. A swap is an exchange of cash payment obligations in which each party prefers the payment type of the other party. Generally, one party has a fixed-rate obligation and the other a floating-rate obligation, or one has an obligation denominated in one currency and the other in another currency. In a swap, two parties agree to swap something, generally obligations to make specified payment streams. Most swaps today involve interest payments ...