A swap is an over-the-counter derivative in which two parties agree to exchange cash flows based on specified terms for a defined period, typically without exchanging principal and with cash flows computed on a notional amount. Swaps allow participants to transform the nature of their assets or liabilities (e.g., from floating to fixed interest) and to manage market risks with precision.
Definition
A swap is a contractual agreement to exchange one series of cash flows for another—most commonly fixed for floating interest payments—on scheduled dates over the life of the contract, calculated on an agreed notional principal that is not exchanged. The contract specifies notional, payment frequency, day-count conventions, reference benchmarks, and start and end dates.
Characteristics
- OTC customization: Terms can be tailored for notional schedules, amortization, payment frequency, day-count, and reference indices, enabling precise hedges.
- No principal exchange: Principal generally remains notional; only net interest cash flows exchange in the same currency.
- Counterparty risk: Exposures are bilateral unless collateralized or cleared; credit support annexes (CSAs) mitigate this via variation margin.
- Market benchmarks: Post‑LIBOR transition, liquid swaps reference near risk-free rates such as SOFR, SONIA, €STR, and in India, MIBOR/OIS for rupee markets.
- Netting and collateral: Portfolio netting across trades reduces gross exposure; daily margining aligns market value and posted collateral.
Swap terminology
- Notional principal: The reference amount used to compute periodic interest cash flows; not exchanged.
- Legs: The fixed leg (pays a fixed rate) and the floating leg (pays a benchmark rate plus/minus spread).
- Fixed rate (swap rate): The par rate that sets the swap’s initial value to zero given the relevant discount and forward curves.
- Floating index: Reference rate for resets (e.g., 3M SOFR, MIBOR), with reset and payment dates per market convention.
- Day-count and frequency: Conventions such as ACT/360, 30/360; payment schedules such as quarterly, semiannual.
- Effective and maturity dates: Start and end of the accrual period structure; may include stubs for alignment.
Types of swaps
- Interest rate swaps (IRS): Exchange fixed for floating (plain vanilla), floating for floating of different tenors (basis swaps), or link to overnight indices (OIS).
- Currency (cross-currency) swaps: Exchange principal and interest in two currencies, often fixed–fixed or fixed–floating across currencies.
- Total return swaps (TRS): Exchange total return on an asset or index for a financing leg, transferring economic exposure without ownership.
- Commodity swaps: Exchange fixed commodity price for floating (index-based) price streams.
- Equity swaps: Exchange equity index total return for a fixed or floating rate leg.
Interest rate swap (plain vanilla)
In a fixed-for-floating IRS, Party A pays a fixed rate on the notional and receives a floating benchmark; Party B pays floating and receives fixed. The floating leg resets to the prevailing benchmark at each reset date; payments occur on scheduled payment dates, typically netted so only one cash flow changes hands. The fixed rate is set at inception so that the present value (PV) of fixed leg cash flows equals the PV of expected floating leg cash flows under the current curve.
Calculating IRS cash flows
- Fixed leg coupon per period: Fixed rate × year_fraction × notional.
- Floating leg coupon per period: Observed reset rate × year_fraction × notional (rate observed at reset date for the upcoming accrual period).
- Discounting: Each leg’s cash flows are discounted using the appropriate discount curve consistent with collateral and benchmark (e.g., OIS discounting for SOFR-collateralized trades).
- Par swap rate: Chosen so PV(fixed leg) = PV(floating leg) at trade date, implying initial swap value ≈ 0. The formula is:
- Fixed rate = [1 − D(T_n)] / Σ_{i=1..n} D(T_i) × year_fraction_i
where D(T_i) are discount factors for each payment date T_i.
- Fixed rate = [1 − D(T_n)] / Σ_{i=1..n} D(T_i) × year_fraction_i
- Mark-to-market value: After inception, value equals PV(received leg) − PV(paid leg), changing with curve shifts and time decay.
Uses of interest rate swaps
- Liability management: Convert floating-rate debt to fixed to lock borrowing costs, or fixed to floating to benefit from anticipated rate declines.
- Asset–liability matching: Align asset and liability duration profiles for banks, NBFCs, and insurers to stabilize net interest income.
- Yield enhancement and positioning: Express views on curve shape (e.g., receive fixed long-end vs pay fixed short-end) or implement carry/roll strategies.
- Hedge accounting: Qualify fair value or cash flow hedge relationships to reduce P&L volatility, with documentation and effectiveness testing.
Pricing of swaps (intuition)
- Par swap rate equals a weighted average of forward rates over the payment schedule, with weights proportional to discount factors and accrual fractions.
- Discounting uses collateral-consistent curves (OIS discounting standard in many markets); projection of floating cash flows uses the corresponding forward curve.
- Credit and funding: Bilateral credit risk, funding valuation adjustment (FVA), and credit valuation adjustment (CVA) can impact executable levels and internal valuation.
Swaptions
A swaption is an option on a swap, granting the right but not the obligation to enter a specified IRS on a future date.
- Types: Payer swaption (right to pay fixed/receive floating, benefits if rates rise); Receiver swaption (right to receive fixed/pay floating, benefits if rates fall).
- Styles: European (exercise only at expiry), Bermudan (exercise on a schedule), American (exercise anytime within a window, less common in IRS).
- Uses:
- Hedging callable risk and cap/floor-like exposures with more targeted duration convexity.
- Protecting against adverse rate moves while retaining upside if rates move favorably.
- Valuation drivers: Forward swap rate (the underlying), volatility surface (normal/lognormal), annuity (PV of fixed leg cash flows), and discounting curve; standard models include Black’s swaption formula and more advanced rate models.
Worked mini-example (illustrative)
- Situation: A company has a 5-year floating-rate loan on 6M resets and wants fixed payments.
- Solution: Enter a 5-year pay-fixed/receive-floating IRS on matching notional, payment frequency, and day-count.
- Cash flows:
- Each six months, pay fixed coupon = fixed_rate × accrual × notional.
- Receive floating coupon = reset_rate × accrual × notional (reset set at period start).
- Outcome: Net cash flow variability is reduced; effective liability behaves like fixed-rate debt for the hedge horizon.
Risk management and governance
- Documentation: Use ISDA Master Agreement with Credit Support Annex for margin terms, eligible collateral, thresholds, and close-out mechanics.
- Curve and model control: Independent curve construction, day-count/holiday alignment, and regular validation of pricing models and inputs.
- Counterparty and wrong-way risk: Monitor exposures, concentration, and correlations between the counterparty’s credit quality and market factors driving positive MTM.
- Operational controls: Accurate scheduling, confirmation matching, and lifecycle events (resets, stubs, holidays) to avoid settlement errors.
This educational primer covers what swaps are, how they are structured and valued, the specifics of interest rate swaps and their cash flows, practical use cases for hedging and balance sheet management, and how swaptions provide optionality on future swap exposures. If a Word-formatted version or Indian market references (e.g., MIBOR, OIS conventions) are desired, the content can be adapted to a house style and localized benchmarks.
CAIIB exam Risk Management related articles in model “F” (elective paper)
