CH 14: Interest Rate and Currency Swaps
Types of Swaps
In a swap, two counterparties agree to a contractual arrangement wherein they agree to exchange cash flows at periodic intervals.
2 Types of interest rate swaps:
Single currency interest rate swaps—“Plain vanilla” fixed-for-floating swaps are often just called interest rate swaps. One counter party exchanges the interest payments of a floating-rate debt obligation for the fixed-rate interest payments of the other counterparty.
Cross-currency interest rate swap—This is often called a currency swap. It is fixed for fixed-rate debt service in two (or more) currencies. One counterparty exchanges the debt service obligations of a bond denominated in one currency for the debt service obligations of the other counterparty denominated in another currency.
Size of the Swap Market
The Swap Bank
A swap bank is a generic term to describe a financial institution that facilitates swaps between counterparties.
Can serve as either a broker or a dealer.
As a broker, the swap bank matches counterparties but does not assume any of the risks of the swap.
As a dealer, the swap bank stands ready to accept either side of a currency swap and then later lay off their risk or match it with a counterparty.
Swaps offer market completeness and that has accounted for their existence and growth.
Size is measured by notional principal, a reference amount of principal used for determining payments under various derivative contracts.
Swaps assist in tailoring financing to the type desired by a particular borrower. Since not all types of debt instruments are available to all types of borrowers, both counterparties can benefit (as well as the swap dealer) through financing that is more suitable for their asset maturity structures.
The Quality Spread Differential
The Quality Spread Differential represents the potential gains from the swap that can be shared between the counterparties and the swap bank.
Currency swaps evolved from parallel and back to back loans, a way to hedge long-term foreign exchange exposure.
Variations of Basic Currency and Interest Rate Swaps
Currency swaps
fixed for fixed
fixed for floating
floating for floating
amorizing
Interest Rate Swaps
Zero for floating
floating for floating
For a swap to be possible, a QSD must exist. Beyond that, creativity is the only limit.
Risks of Interest Rate and Currency Swaps:
Interest Rate Risk - Interest rates might move against the swap bank after it has only gotten half of a swap on the books or if it has an unhedged position.
Basis Risk - If the floating rates of the two counterparties are not pegged to the same index.
Credit Risk - This is the major risk faced by a swap dealer, the risk that a counter party will default on its end of the swap.
Mismatch Risk- Its hard to find a counterparty that wants to borrow the right amount of money for the right amount of time.
Sovereign Risk - The risk that a country will impose exchange rate restrictions that will interfere with performance on the swap.
Pricing a Swap:
A swap is a derivative security so it can be priced in terms of the underlying assets.
Plain vanilla fixed for floating swap gets valued just like a bond.
Currency swap gets valued just like a nest of currency futures.
Summary
Swaps are off-the-books transactions.
A basic interest rate swap is a fixed for floating rate exchange, where one party agrees to swap interest obligations on a fixed rate instrument with a counterparty who has a floating rate obligation.
There is no exchange of principal, interest rates are based on a notional principal amount.
The currency swap market began with parallel and back-to-back loans.