Privacy Settings
Functional cookies, which are necessary for basic site functionality like keeping you logged in, are always enabled.
2024 Curriculum CFA Program Level I Derivatives
Introduction
Swap contracts were introduced earlier as a firm commitment to exchange a series of cash flows in the future. Interest rate swaps in which fixed cash flows are exchanged for floating payments are the most common type. Subsequent lessons addressed the pricing and valuation of forward and futures contracts across the term structure, which form the building blocks for swap contracts.
In this lesson, we will explore how swap contracts are related to these other forward commitment types. Although financial intermediaries often use forward rate agreements or short-term interest rate futures contracts to manage interest rate exposure, issuers and investors usually prefer swap contracts, because they better match rate-sensitive assets and liabilities with periodic cash flows, such as fixed-coupon bonds, variable-rate loans, or known future commitments. It is important for these market participants not only to be able to match expected future cash flows using swaps but also to ensure that their change in value is consistent with existing or desired underlying exposures. The following lessons compare swap contracts with forward contracts and contrast the value and price of swaps.
Learning Outcomes
The member should be able to:
- describe how swap contracts are similar to but different from a series of forward contracts, and
- contrast the value and price of swaps.
Summary
- A swap contract is an agreement between two counterparties to exchange a series of future cash flows, whereas a forward contract is a single exchange of value at a later date.
- Interest rate swaps are similar to forwards in that both contracts are firm commitments with symmetric payoff profiles and no cash is exchanged at inception, but they differ in that the fixed swap rate is constant, whereas a series of forward contracts has different forward rates at each maturity.
- A swap is priced by solving for the par swap rate, a fixed rate that sets the present value of all future expected floating cash flows equal to the present value of all future fixed cash flows.
- The value of a swap at inception is zero (ignoring transaction and counterparty credit costs). On any settlement date, the value of a swap equals the current settlement value plus the present value of all remaining future swap settlements.
- A swap contract’s value changes as time passes and interest rates change. For example, a rise in expected forward rates increases the present value of floating payments, causing a mark-to-market (MTM) gain for the fixed-rate payer (floating-rate receiver) and an MTM loss for the fixed-rate receiver (floating-rate payer).
FAQs
A swap is priced by solving for the par swap rate, a fixed rate that sets the present value of all future expected floating cash flows equal to the present value of all future fixed cash flows. The value of a swap at inception is zero (ignoring transaction and counterparty credit costs).
What is pricing and valuation of currency swaps? ›
Pricing Currency Swaps
Pricing a currency swap involves solving the appropriate notional amount in one currency, given the notional amount in the other currency, and determining the two fixed interest rates. The currency swap value is zero at the time of initiation.
What is the formula for the price of a swap? ›
The swap pricing equation, which sets r FIX for the implied fixed bond in an interest rate swap, is: rFIX=1−PVn(1)∑ni=1PVi(1) r F I X = 1 − PV n ( 1 ) ∑ i = 1 n PV i ( 1 ) .
What is an example of an interest rate swap? ›
Since the company is worried that interest rates may rise, it finds Company B that agrees to pay Company A the LIBOR annual rate plus 1% for two years on the notional principal of $10 million. In exchange, Company A pays Company B a fixed rate of 4% on a notional value of $10 million for two years.
What is an example of a swap? ›
For example, a company paying a variable rate of interest may swap its interest payments with another company that will then pay the first company a fixed rate. Swaps can also be used to exchange other kinds of value or risk like the potential for a credit default in a bond.
What is interest rate swap in simple terms? ›
An interest rate swap is a contractual arrangement be- tween two parties, often referred to as “counterparties”. As shown in Figure 1, the counterparties (in this example, a financial institution and an issuer) agree to exchange payments based on a defined principal amount, for a fixed period of time.
How to value a cross-currency interest rate swap? ›
The valuation of a CCS is quite similar to the valuation of an interest-rate swap. The CCS is valued by discounting the future cash flows for both legs at the market interest rate applicable at that time.
What is the valuation of currency? ›
Summary. Currency value is determined by aggregate supply and demand. Supply and demand are influenced by a number of factors, including interest rates, inflation, capital flow, and money supply.
How do you explain swaps? ›
A swap is an agreement for a financial exchange in which one of the two parties promises to make, with an established frequency, a series of payments, in exchange for receiving another set of payments from the other party. These flows normally respond to interest payments based on the nominal amount of the swap.
How do swaps benefit investors? ›
A swap contract involves the exchange of cash flows from an underlying asset. The major benefit of swaps is that it allows investors to hedge their risk while also allowing them to explore new markets.
For derivatives, it's crucial to distinguish between price and value. The price of a forward or futures contract is the agreed-upon payment for the underlying on the settlement date, denoted by “big F”. On the other hand, the value of a contract is the gain or loss to the contract party, denoted by “big V”.
How do you calculate mark to market interest rate swap? ›
The value of the swap or MtM, is the just net difference between the floating and fixed legs. Said another way, the MtM is the present value sum of the difference between the fixed payments and floating payments (based on market projections at that moment) until maturity.
How do interest rate swaps hedge risk? ›
Swaps may be used to hedge against adverse interest rate movements or to achieve a desired balanced between fixed and variable rate debt. Interest rate swaps allow both counterparties to benefit from the interest payment exchange by obtaining better borrowing rates than they are offered by a bank.
How do you price a forward starting swap? ›
Swap dealers calculate the forward fixed swap rate by equating the present value of all of the fixed payments to the present value of the expected floating rate payments implied by the forward curve.
How are equity swaps priced? ›
Equity Swap Valuation
The price of the swap is the difference between the present values of both legs' cash flows. In other words, the present value of swap is net of present value of “equity leg” and “money market leg”.
How are compounding swaps valued? ›
Compounding swaps can be valued by assuming that the forward rates are realized. Normally the calculation period of a compounding swap is smaller than the payment period. For example, an interest rate swap has 6-month payment period and 1-month calculation period (or 1-month index tenor).
