Principles of Financial Engineering, 2nd Edition

CHAPTER 5

Introduction to Swap Engineering

1. The Swap Logic

Swaps are the first basic tool that we introduced in Chapter 1. It should be clear by now that swaps are essentially the generalization of what was discussed in Chapters 1, 3 and 4. We start this chapter by providing a general logic for swaps.

It is important to realize that essentially all swaps can be combined under one single logic. Consider any asset. Suppose we add to this asset another contract and form a basket. But, suppose we choose this asset so that the market risk, or the volatility associated with it, is exactly zero. Then the volatility (or the risk) of the basket is identical to the volatility (or the risk) of the original asset. Yet, the addition of this “zero” can ...