A brief overview on swaps!

1. A Day in life of a Swap!
Sapna Desai

2. Contents
• Definition
• Cash flows of a Swap
• Valuation of a Swap
• Interest Rate risk on a swap
• Credit Risk on a swap
• Uses of Swap
• Swap Spread
• Regulatory mandates to clear OTC Derivatives

3. What is a Swap
• Two parties agree to exchange interest payments
calculated at a fixed rate for interest payments
calculated at a short term rate that changes over
time
Example:
Party A pays 1.235% fixed to party B on 100mm
notional semi- annually for two years and
receives 3 month libor quarterly for same time
period.

4. Swap Cash Flows
• Swap settles T+2
3 month Libor Pmt date actual days A pays B Pays
0.5 6/2/2010
0.75 9/2/2010 92 127,777.78
0.75 12/2/2010 91 617,500.00 189,583.00
0.75 3/2/2011 90
0.75 6/2/2011 92
1 9/2/2011 92
1 12/2/2011 91
1 3/2/2012 91
6/4/2012 94

5. Valuation of a Swap
• Fixed leg = sum of all the cash flows( including
the fictional cash flow)
• Float leg = 100 + accrued interest
Pricing of swap as of May 28, 2010 for a swap that settled on Dec 15th, 2009
Previous libor setting = .257%
fixed rate = 1.386%
Date DF Fixed Cashflow Float Cashflows
6/15/2010 0.99 .5*1.386 100+92/360*.257
12/15/2010 0.99 .5*1.387
6/15/2011 0.99 .5*1.388
12/15/2011 0.99 .5*1.389+100
PV 101.15 100.05
NPV 1.1

6. Value of float leg
• Pricing of the floating leg of a swap, the
instant the LIBOR setting is observed, the
value of the floating leg as of the beginning of
the next interest accrual period is PAR.
• 100+100(1+L*d/360)/(1+L*d/360)= 100

7. Interest Rate Risk
100mm received fixed Swap; say 8 cents on 100 is Duration for a 10 yr security.
.08 on 100, 8 on 10000; 80 on100000, 80000 on 100000000.
Value of the fixed leg depends on relatively long term rates while value of floating leg
depends on short term rates
Node Risk
o/n
1m
3m
6m
1y
5y
10y +80K
12y
15y
20y

8. Credit Risk
• Libor is a rate on an unsecured short term
loan between large financial institutions.
• Libor is a above rates if similar short term
maturities or secured repo transactions.

9. Uses of Swaps
• To hedge future issuance of 10yr debt-pay fixed
on a swap and unwind it at the time of issuance
• Synthetic floating rate debt- instead of issuing
short term debt or long term floating debt, one
can issue fixed rate debt and receive fixed thus
have net floating rate funding at some spread
over LIBOR
• Mortgage hedging
• Insurance companies to offset mismatch of
durations between their assets and liabilities.

10. Type of Trades
• Outright Swap(Market view:receive fixed-
Long markets; pay fixed: Short markets)
• DV01 weighted Steepener/Flattener(View on
the curve)
• Swap Spreads(spread over treasury)

11. Swap Spread
• Pay fixed on swap; long treasury bond= long
spreads (one wants the spread to go up)
• Receive fixed on swap; short treasury bond=
short spreads(one wants the spread to come
in)
• It’s a view on the spreads, not outright risk on
duration.

12. Clearing
• Regulators and now the Dodd Frank law
mandate clearing of various OTC derivatives
• CCP
If counterparty A wants to receive fixed and
pay float, it gets into a contract with CCP to
receive fixed and counterparty B can get into a
contract with CCP to pay fixed and receive
float.
• CCP sets Collateral Agreements

13. QnA