Swaps Overview and Definitions

Flashcards covering key concepts and definitions related to swaps for exam preparation.

What is a swap?

An agreement between two parties to exchange assets or a series of cash flows over a specified period.

What are the five generic types of swaps?

1. Interest rate swap 2. Currency swap 3. Credit default swap 4. Commodity swap 5. Equity swap

What is the main question addressed in the lecture regarding financial institutions?

How can financial institutions measure and manage financial risk to maximize shareholders’ and stakeholders’ wealth?

In a credit default swap, who sells and who buys the risk?

The seller (e.g., corporation) sells the risk, and the buyer (e.g., insurance company) buys the risk.

What is the purpose of interest rate swaps?

To convert variable-rate instruments into fixed-rate instruments to better match the duration of assets and liabilities.

What does a currency swap involve?

The exchange of principal amounts and interest payments in different currencies between two parties.

What is a commodity swap?

A contract to exchange cash flows, allowing investors to hedge against price swings in the market for a commodity.

What are the two types of payments in an interest rate swap?

Fixed interest payments and floating interest payments.

What is an example of a situation leading to financial losses from swaps?

The credit default swaps leading to the failure of Lehman Brothers and Merrill Lynch during the financial crisis.

Define macro-hedging in the context of swaps.

An investment technique used to mitigate systemic risk from a portfolio of assets.

What are off-market swaps?

Swaps with non-standard terms that require compensation between parties to accept non-standard terms.

Who are the major participants in the swap market?

Commercial and investment banks acting as dealers, traders, and users.

What role does a swap dealer play?

They act as intermediaries and can reduce credit risk exposure between swap parties.

What are the transaction costs associated with swaps compared to options and forwards?

Costs are highest for options, next for swaps, and forwards have no upfront payments.

What is netting in swap payments?

A process by which payments between parties are offset to mitigate credit risk.

What is the significance of the International Swaps and Derivatives Association (ISDA)?

It sets codes and standards for swap markets and governs transactions.

What is a total return swap?

A swap that involves paying interest rates in exchange for total return on a specified loan or bond.

What does a financial institution do when it has a duration gap?

It may enter into swaps to hedge against interest rate changes that affect equity value.

What type of risk do commodity swaps hedge against?

Price swings in the market for commodities.

What is a pure credit swap?

A swap where an FI receives the par value of a loan on default in return for periodic payments.