The document discusses different types of swaps, including interest rate swaps, cross currency swaps, and credit default swaps. It defines a swap as an agreement between two counterparties to exchange cash flows based on an underlying asset. It provides examples of how interest rate swaps, cross currency swaps, and equity swaps work. The key aspects of each swap type are described, such as the cash flows exchanged and calculation of payments.

1. SWAPSSWAPS

2. IntroductionIntroduction
What is Swap?What is Swap?
Exchanging things is called Swap. It can be anything you may beExchanging things is called Swap. It can be anything you may be
swappingswapping your pen, mobile etc., with your friends.your pen, mobile etc., with your friends.
History of Swap?History of Swap?
In ancient medieval period there was no currency or money. SoIn ancient medieval period there was no currency or money. So
people use to exchange things i.e. Farmer exchanging Rice withpeople use to exchange things i.e. Farmer exchanging Rice with
Cobbler for Shoes, this was called as Barter System.Cobbler for Shoes, this was called as Barter System.
Swap has evolved from Barter system.Swap has evolved from Barter system.

3. Define - SWAPDefine - SWAP
A Swap is an agreement between twoA Swap is an agreement between two
parties to Exchange Cash Flowsparties to Exchange Cash Flows
based on underlying asset.based on underlying asset.

4.  Demand & SupplyDemand & Supply
 Two CounterpartiesTwo Counterparties
 Mutual AgreementMutual Agreement
 Rate of InterestRate of Interest
 Notional AmountNotional Amount
 Trade Date/Effective DateTrade Date/Effective Date
 Settlement Date/Payment Date/ Maturity.Settlement Date/Payment Date/ Maturity.
 Refix dateRefix date
 Accrual Date & End of Accrual DateAccrual Date & End of Accrual Date
 Coupon InterestCoupon Interest
REQUISITE FOR SWAP

5. FEES FOR SWAPFEES FOR SWAP
Brokerage / Consultancy FeeBrokerage / Consultancy Fee
Loading Fee / Entry FeeLoading Fee / Entry Fee
Admin FeeAdmin Fee
Assignment FeeAssignment Fee
Exit Fee/Termination FeeExit Fee/Termination Fee

6. Types of Swaps:Types of Swaps:
 Interest Rate SwapInterest Rate Swap
 Cross Currency SwapCross Currency Swap
 Circus SwapCircus Swap
 Callable SwapCallable Swap
 Putable SwapPutable Swap
 Credit Default SwapCredit Default Swap
 Equity SwapEquity Swap
 Equity Default SwapEquity Default Swap
 Commodity SwapCommodity Swap
 SwaptionSwaption

7. Calculation of CouponCalculation of Coupon
Trade Date Accrual Date
Accrual End
Date
Maturity date
Coupon Period
Coupon= Notional Amount*No of Days * Roi * Day Count Basis
Eg:- Day Count Basis 30/360, ACT/360 , ACT/ACT

8. Trade Date
01/01/06
Effective Date
03/01/06
Settlement Date
31/06/06
Refix Date
28/06/06
Stub
TIMELINE OF SWAP

9. Interest Rate SWAPInterest Rate SWAP

10. DefinitionsDefinitions
In a swap, twoIn a swap, two counterpartiescounterparties agree toagree to
a contractual arrangement wherein theya contractual arrangement wherein they
agree to exchange cash flows at periodicagree to exchange cash flows at periodic
intervals.intervals.
Fixed Interest rate to Floating Interest rateFixed Interest rate to Floating Interest rate
Floating Interest rate to Fixed Interest rateFloating Interest rate to Fixed Interest rate

11. Size of the Swap MarketSize of the Swap Market
In 2001 the notational principal of:In 2001 the notational principal of:
Interest rate swaps was $58,897,000,000.Interest rate swaps was $58,897,000,000.
Currency swaps was $3,942,000,000Currency swaps was $3,942,000,000
The most popular currencies are:The most popular currencies are:
U.S. dollarU.S. dollar
Japanese yenJapanese yen
EuroEuro
Swiss francSwiss franc
British pound sterlingBritish pound sterling

12. Lender
ABC CO.
AAA Rating
Lender
XYZ CO.
BBB Rating
Borrow $10MM
Fixed 6%
Borrow $10MM
Libor + 1%
In Market
ABC is getting
Fixed @ 6 %
Floating @ Libor
In Market
XYZ is getting
Fixed @ 10 %
Floating @ Libor + 1%
EXAMPLE

13. ABC CO.
AAA Rating
XYZ CO.
BBB Rating
ABC will give LIBOR
XYZ will give Fixed 8%
ABC XYZ Comparative Advantage
(ABC)
FIXED 7% 10% 3%
Floating Libor Libor + 1% 1%
Net 2%
QSD = 7% + 2% - 1 % = 8 %
The Quality Spread Differential represents the potential gains from the swapThe Quality Spread Differential represents the potential gains from the swap

14. Advantages of Interest RateAdvantages of Interest Rate
SwapSwap
Swapping from fixed to floating may saveSwapping from fixed to floating may save
issuer money.issuer money.
Protects against adverse movements inProtects against adverse movements in
interest rates.interest rates.
No premium is paid to enter into a swap.No premium is paid to enter into a swap.
No principal amount is exchanged.No principal amount is exchanged.

15. Cross Currency SwapCross Currency Swap

16. DefinitionsDefinitions
In a Cross currency swap, twoIn a Cross currency swap, two
counterpartiescounterparties agree to a contractualagree to a contractual
arrangement wherein they agree toarrangement wherein they agree to
exchange their currencies.exchange their currencies.
E.g.E.g.
USD being exchanged with GBPUSD being exchanged with GBP
AUD being exchanged with USDAUD being exchanged with USD

17. Example of Cross Currency SwapExample of Cross Currency Swap
Issue Bonds of
£10mm @ 5%
Tesco in UK
Start a Co. in
US
Require
Pounds
Issue Bonds of
$16mm @5%
McDonalds
in US
Start a Co. in
UK
Require
Dollars
Tesco will exchange Currency
with McDonalds

18. Circus SwapCircus Swap
In a Circus Swap ,twoIn a Circus Swap ,two counterpartiescounterparties
agree to a contractual arrangementagree to a contractual arrangement
wherein they agree to exchange theirwherein they agree to exchange their
Notional Amount and Interest Rate.Notional Amount and Interest Rate.

19. Example of Circus SwapExample of Circus Swap
Issue Bonds of
£10mm @ 5%
Tesco in UK
Start a Co. in
US
Require
Pounds
Issue Bonds of
$16mm @5%
McDonalds
in US
Start a Co. in
UK
Require
Dollars
Tesco will exchange Interest
Rate & Notional Amount
with McDonalds

20. Callable Swap:-Callable Swap:-
When a counterparty is receiving Fixed rateWhen a counterparty is receiving Fixed rate
of Interestof Interest
Putable Swap:-Putable Swap:-
When a Counterparty is paying Fixed rate ofWhen a Counterparty is paying Fixed rate of
InterestInterest
Callable & Putable SwapCallable & Putable Swap

21. Credit Default Swap (CDS)Credit Default Swap (CDS)

22. CDS – An OverviewCDS – An Overview
 A credit default swap is an agreement by one party to accept aA credit default swap is an agreement by one party to accept a
premium at regular intervals in return for making a largerpremium at regular intervals in return for making a larger
payment if a specific company defaults, goes bankrupt, or sufferspayment if a specific company defaults, goes bankrupt, or suffers
a negative credit event.a negative credit event.
 It is an agreement between a protection buyer and a protectionIt is an agreement between a protection buyer and a protection
seller whereby the buyer pays a periodic fee in return for aseller whereby the buyer pays a periodic fee in return for a
contingent payment by the seller upon a credit event (such as acontingent payment by the seller upon a credit event (such as a
certain default) happening in the reference entity.certain default) happening in the reference entity.
 A CDS is often used like an insurance policy, or hedge for theA CDS is often used like an insurance policy, or hedge for the
holder of a corporate bond.holder of a corporate bond.
 In a CDS the buyer of protection ("Buyer") typically pays aIn a CDS the buyer of protection ("Buyer") typically pays a
periodic fee in exchange for the seller of protection ("Seller")periodic fee in exchange for the seller of protection ("Seller")
contracting to make a payment.contracting to make a payment.

23. CDS – PROCESS FLOWCDS – PROCESS FLOW
BOND ISSUER
INVESTOR
PROTECTION
SELLER
$10 MM 6% Quarterly Fee
( 200 bps )
Bond
Bond Value

24. CDS- An ExampleCDS- An Example
 A pension fund owns 10 Mn Euros worth of a 5 year bond issued byA pension fund owns 10 Mn Euros worth of a 5 year bond issued by
X Corp.X Corp.
 To manage the risk, they buy a CDS from Derivative Bank on aTo manage the risk, they buy a CDS from Derivative Bank on a
nominal of 10 million euros which trades at 200 basis points.nominal of 10 million euros which trades at 200 basis points.
 The pension fund pays a premium of 2% of 10 million (200,000The pension fund pays a premium of 2% of 10 million (200,000
euros per annum) as quarterly payments Derivative Bank.euros per annum) as quarterly payments Derivative Bank.
 In case of no default PF receives 10 Mn Euros on completion ofIn case of no default PF receives 10 Mn Euros on completion of
quarterly payments for 5 years.quarterly payments for 5 years.
 If X Corp. defaults on its debt 3 years into the CDS contract then theIf X Corp. defaults on its debt 3 years into the CDS contract then the
premium payments would stop and Derivative Bank would ensurepremium payments would stop and Derivative Bank would ensure
that the pension fund is refunded for its loss of 10 million euros.that the pension fund is refunded for its loss of 10 million euros.

25. Credit eventsCredit events
Types of Credit Events:Types of Credit Events:
Bankruptcy by the Reference CreditBankruptcy by the Reference Credit
RestructuringRestructuring
Failure to Pay a pre-agreed asset orFailure to Pay a pre-agreed asset or
assets ("Reference Obligation")assets ("Reference Obligation")

26. Settlement of CDSSettlement of CDS
 Cash Settlement - Reference obligationCash Settlement - Reference obligation
minus its post-default trading value asminus its post-default trading value as
determined by a pre-agreed dealer polldetermined by a pre-agreed dealer poll
mechanism.mechanism.
 Physical Delivery - Transfer of a pre-agreedPhysical Delivery - Transfer of a pre-agreed
asset or assets ("Deliverable Obligation") toasset or assets ("Deliverable Obligation") to
the seller in exchange for a payment equal tothe seller in exchange for a payment equal to
the notional of the contract.the notional of the contract.

27. EQUITY SWAPEQUITY SWAP

28. Equity SWAPS - An OverviewEquity SWAPS - An Overview
 Equity swap is a transaction between two parties in which each party agreesEquity swap is a transaction between two parties in which each party agrees
to make a series of payments to the other, with at least one set of paymentsto make a series of payments to the other, with at least one set of payments
determined by the return on a stock or stock index.determined by the return on a stock or stock index.
 The return is calculated based on a pre-determined notional principal andThe return is calculated based on a pre-determined notional principal and
may or may not include dividends.may or may not include dividends.
 The payments occur on regularly scheduled dates over a specified period ofThe payments occur on regularly scheduled dates over a specified period of
time.time.
 Equity swaps are offered by derivatives dealers in much the same mannerEquity swaps are offered by derivatives dealers in much the same manner
as their offerings of interest rate, currency, and commodity swaps.as their offerings of interest rate, currency, and commodity swaps.
 Dealers typically charge a bid-ask spread and hedge any risk they haveDealers typically charge a bid-ask spread and hedge any risk they have
assumed by transacting in the underlying stock or index or anotherassumed by transacting in the underlying stock or index or another
derivative on the stock or index.derivative on the stock or index.

29. Type of Equity SWAPSType of Equity SWAPS
There are three main types of equity swaps:There are three main types of equity swaps:
 An Equity Swap with the Equity ReturnAn Equity Swap with the Equity Return
paid against a Fixed Ratepaid against a Fixed Rate
 An Equity Swap with the Equity ReturnAn Equity Swap with the Equity Return
paid against a Floating Ratepaid against a Floating Rate
 An Equity Swap with the Equity ReturnAn Equity Swap with the Equity Return
paid against another Equity Returnpaid against another Equity Return

30. Example - Equity Return Paid Against aExample - Equity Return Paid Against a
Fixed RateFixed Rate
 On December 15 of a given year, Dynamic Money
Management enters into a swap to pay a fixed rate of
5% with payment terms of 30/360 and receive the return
on the S&P 500 with payments to occur on March 15,
June 15, September 15, and December 15 for one year.
 Payments will be calculated on a notional principal of
$20 million.
 The counterparty is the swaps dealer Total Swaps, Inc.The counterparty is the swaps dealer Total Swaps, Inc.
The S&P 500 is at 1105.15 on the day the swap isThe S&P 500 is at 1105.15 on the day the swap is
initiated.initiated.

31. Example -Example - Equity Return PaidEquity Return Paid
Against a Fixed RateAgainst a Fixed Rate
 On each settlement date, the return on the S&POn each settlement date, the return on the S&P
500 is calculated and applied to the $20 million500 is calculated and applied to the $20 million
notional principal to determine the payment to benotional principal to determine the payment to be
received.received.
 The fixed payment is based on 5% and anThe fixed payment is based on 5% and an
adjustment factor of 90/360 applied to $20adjustment factor of 90/360 applied to $20
million.million.
 As is customary in swaps, the difference in theAs is customary in swaps, the difference in the
two payments is determined and only the net, astwo payments is determined and only the net, as
indicated in the last column, is paid.indicated in the last column, is paid.

32. Example -Example - Equity Return PaidEquity Return Paid
Against a Fixed RateAgainst a Fixed Rate
DateDate S&P 500S&P 500
IndexIndex
PeriodicPeriodic
Return onReturn on
S&P 500S&P 500
S&P 500S&P 500
Cash FlowCash Flow
FixedFixed
Interest CashInterest Cash
FlowFlow
Net CashNet Cash
FlowFlow
Dec 15Dec 15 1105.151105.15
Mar 15Mar 15 1129.481129.48 2.2015%2.2015% $440,300$440,300 -$250,000-$250,000 $190,300$190,300
Jun 15Jun 15 1084.301084.30 -4.0001%-4.0001% -800,020-800,020 -250,000-250,000 -1,050,020-1,050,020
Sept 15Sept 15 1055.291055.29 -2.6755%-2.6755% -535,100-535,100 -250,000-250,000 -785,100-785,100
Dec 15Dec 15 1099.521099.52 4.1913%4.1913% 838,260838,260 -250,000-250,000 588,260588,260

33. Example - Equity Return paidExample - Equity Return paid
against a Floating Rateagainst a Floating Rate
 On December 15 of a given year, Dynamic MoneyOn December 15 of a given year, Dynamic Money
Management enters into a swap to pay a floating rate ofManagement enters into a swap to pay a floating rate of
90-day LIBOR with payment terms of 30/360 and receive90-day LIBOR with payment terms of 30/360 and receive
the return on the S&P 500 with payments to occur onthe return on the S&P 500 with payments to occur on
March 15, June 15, September 15, and December 15 forMarch 15, June 15, September 15, and December 15 for
one year.one year.
 Payments will be calculated on a notional principal ofPayments will be calculated on a notional principal of
$20 million.$20 million.
 The counterparty is the swaps dealer Total Swaps, Inc.The counterparty is the swaps dealer Total Swaps, Inc.
The S&P 500 is at 1105.15 and 90-day LIBOR is 4.75%The S&P 500 is at 1105.15 and 90-day LIBOR is 4.75%
on the day the swap is initiated.on the day the swap is initiated.

34. Example - Equity Return paidExample - Equity Return paid
against a Floating Rateagainst a Floating Rate
DateDate S&P 500S&P 500
IndexIndex
PeriodicPeriodic
Return onReturn on
S&P 500S&P 500
S&P 500S&P 500
Cash FlowCash Flow
LIBORLIBOR LIBORLIBOR
Cash FlowCash Flow
Net CashNet Cash
FlowFlow
Dec 15Dec 15 1105.151105.15 4.75%4.75%
Mar 15Mar 15 1129.481129.48 2.2015%2.2015% $440,300$440,300 4.875%4.875% -$237,500-$237,500 $202,800$202,800
Jun 15Jun 15 1084.301084.30 -4.0001%-4.0001% -800,020-800,020 5.125%5.125% -243,750-243,750 -1,043,770-1,043,770
Sept 15Sept 15 1055.291055.29 -2.6755%-2.6755% -535,100-535,100 4.9375%4.9375% -256,250-256,250 -791,350-791,350
Dec 15Dec 15 1099.521099.52 4.1913%4.1913% 838,260838,260 notnot
applicableapplicable
-246,875-246,875 591,385591,385

35. Example - Equity Return Paid AgainstExample - Equity Return Paid Against
Another EquityAnother Equity ReturnReturn
 On December 15 of a given year Dynamic MoneyOn December 15 of a given year Dynamic Money
Management enters into a swap to pay the return on theManagement enters into a swap to pay the return on the
NASDAQ Composite index and receive the return on theNASDAQ Composite index and receive the return on the
S&P 500 with payments to occur on March 15, June 15,S&P 500 with payments to occur on March 15, June 15,
September 15, and December 15 for one year.September 15, and December 15 for one year.
 Payments will be calculated on a notional principal ofPayments will be calculated on a notional principal of
$20 million.$20 million.
 The counterparty is the swaps dealer Total Swaps, Inc.The counterparty is the swaps dealer Total Swaps, Inc.
The S&P 500 is at 1105.15 and NASDAQ is at 1705.51.The S&P 500 is at 1105.15 and NASDAQ is at 1705.51.

36. Example - Equity Return PaidExample - Equity Return Paid
Against Another EquityAgainst Another Equity ReturnReturn
DateDate S&PS&P
500500
IndexIndex
PeriodicPeriodic
Return onReturn on
S&P 500S&P 500
S&P 500S&P 500
CashCash
FlowFlow
NASDAQNASDAQ
IndexIndex
PeriodicPeriodic
Return onReturn on
NASDAQNASDAQ
NASDAQNASDAQ
Cash FlowCash Flow
Net CashNet Cash
FlowFlow
Dec 15Dec 15 1105.151105.15 1705.511705.51
Mar 15Mar 15 1129.481129.48 2.2015%2.2015% $440,300$440,300 1750.781750.78 2.6543%2.6543% -$530,860-$530,860 $202,800$202,800
Jun 15Jun 15 1084.301084.30 -4.0001%-4.0001% -800,020-800,020 1689.251689.25 -3.5144%-3.5144% +702,880+702,880 -1,043,770-1,043,770
Sept 15Sept 15 1055.291055.29 -2.6755%-2.6755% -535,100-535,100 1609.671609.67 -4.7110%-4.7110% +942,200+942,200 -791,350-791,350
Dec 15Dec 15 1099.521099.52 4.1913%4.1913% 838,260838,260 1678.511678.51 4. 2767%4. 2767% -855,340-855,340 591,385591,385

37. COMMODITY SWAPCOMMODITY SWAP

38. Commodity SwapCommodity Swap
DefinitionDefinition
A swap where exchanged cash flows areA swap where exchanged cash flows are
dependent on the price of an underlyingdependent on the price of an underlying
commodity.commodity.
This is usually used to hedge against theThis is usually used to hedge against the
price of a commodity.price of a commodity.

39. Types of commodity swapsTypes of commodity swaps
 Fixed-floatingFixed-floating
 Fixed-floating swaps are just like the fixed-floating swaps in theFixed-floating swaps are just like the fixed-floating swaps in the
interest rate swap market with the exception that both indicesinterest rate swap market with the exception that both indices
are commodity based indicesare commodity based indices..
 Commodity-for-interestCommodity-for-interest
 Commodity-for-interest swaps are similar to the equity swap inCommodity-for-interest swaps are similar to the equity swap in
which a total return on the commodity in question is exchangedwhich a total return on the commodity in question is exchanged
for some money market rate.for some money market rate.

40. Example for Commodity SwapExample for Commodity Swap
 A large US refinery wants to launch a program that would allow theA large US refinery wants to launch a program that would allow the
customers to lock in the price they pay the Refinery for a pre-customers to lock in the price they pay the Refinery for a pre-
specified quantity of oil products during the coming year.specified quantity of oil products during the coming year.
 To protect itself from financial loss arising out of market fluctuation,To protect itself from financial loss arising out of market fluctuation,
the refinery enters into a one-year Fixed for Floating Swap withthe refinery enters into a one-year Fixed for Floating Swap with
Sempra Energy Trading ® Corp. ("SET") to hedge 100,000 barrelsSempra Energy Trading ® Corp. ("SET") to hedge 100,000 barrels
of fuel oil per month at a fixed price of $22.00/bbl.of fuel oil per month at a fixed price of $22.00/bbl.
 Under the swap agreement, the Refinery makes a monthly fixedUnder the swap agreement, the Refinery makes a monthly fixed
payment to SET equal to $22.00/barrel.payment to SET equal to $22.00/barrel.
 SET, in exchange, makes a floating payment to the Refinery basedSET, in exchange, makes a floating payment to the Refinery based
on the arithmetic average of the daily settlement prices of theon the arithmetic average of the daily settlement prices of the
prompt NYMEX crude oil futures contract for each of the Pricingprompt NYMEX crude oil futures contract for each of the Pricing
Periods for which the Reference Price is quoted.Periods for which the Reference Price is quoted.

41. Example-cont.Example-cont.
During the life of the swap,During the life of the swap,
 The Refinery continues to purchase crude it needs from its regularThe Refinery continues to purchase crude it needs from its regular
suppliers, which may include SET, at index prices.suppliers, which may include SET, at index prices.
 On each Settlement Date, the Refinery and SET exchangeOn each Settlement Date, the Refinery and SET exchange
payments equal to the difference between the index price and thepayments equal to the difference between the index price and the
fixed $22.00/bbl swap price.fixed $22.00/bbl swap price.
 The floating payment received from SET should closely approximateThe floating payment received from SET should closely approximate
the payment the Refinery made to its suppliers for physicalthe payment the Refinery made to its suppliers for physical
purchase of crude oil. The net result is that by combining the swappurchase of crude oil. The net result is that by combining the swap
with its current physical crude oil contract, the End User payswith its current physical crude oil contract, the End User pays
$22.00/bbl for its crude oil purchase$22.00/bbl for its crude oil purchase

42. Equity Default SwapEquity Default Swap

43. Equity Default SwapEquity Default Swap
 Equity default swap is a vehicle for one party to provide anotherEquity default swap is a vehicle for one party to provide another
protection against some possible event relating to some company’sprotection against some possible event relating to some company’s
stock.stock.
 The event being protected against is called the trigger event orThe event being protected against is called the trigger event or
knock-in event.knock-in event.
 For example, the equity default swap might provide protectionFor example, the equity default swap might provide protection
against a 70% decline in the stock price from its value when theagainst a 70% decline in the stock price from its value when the
equity default swap was initiated.equity default swap was initiated.
 On the occurrence of trigger event , the equity default swapOn the occurrence of trigger event , the equity default swap
terminates and the protection seller makes a specified payment toterminates and the protection seller makes a specified payment to
the protection buyer.the protection buyer.

44. Equity Default Swap - cont.Equity Default Swap - cont.
 Equity default swap are quoted as spreads overEquity default swap are quoted as spreads over
Libor.Libor.
 Equity default swap truly behaves as a form ofEquity default swap truly behaves as a form of
hybrid between a credit derivative and an equityhybrid between a credit derivative and an equity
derivative.derivative.
 An equity default swap is more likely to beAn equity default swap is more likely to be
triggered than a credit default swap, theytriggered than a credit default swap, they
generally trade at higher spreads than creditgenerally trade at higher spreads than credit
default swap.default swap.

45. Advantages of Equity Default SwapAdvantages of Equity Default Swap
 Trigger events are more easy to define sinceTrigger events are more easy to define since
there is less ambiguity over the stock pricethere is less ambiguity over the stock price
movement.movement.
 Recovery rates are fixed for equity defaultRecovery rates are fixed for equity default
swaps.swaps.
 Equity default swaps can be structured withEquity default swaps can be structured with
various trigger levels loosely corresponding tovarious trigger levels loosely corresponding to
various degrees of corporate impairment.various degrees of corporate impairment.

46. SwaptionSwaption

47. SwaptionSwaption
 A swaption is a financial instrument granting the ownerA swaption is a financial instrument granting the owner
an option to enter swap agreement.an option to enter swap agreement.
 To specify a swaption, there must be three basicTo specify a swaption, there must be three basic
parameters:parameters:
 The expiration date of the option.The expiration date of the option.
 The fixed rate on the underlying swap.The fixed rate on the underlying swap.
 The tenor (time to maturity at exercise of the option) of the swap.The tenor (time to maturity at exercise of the option) of the swap.
 There are two types of settlement possible for aThere are two types of settlement possible for a
swaption contract.swaption contract.
 Physical settlement, , in which case an option is actually enteredPhysical settlement, , in which case an option is actually entered
into upon exercise.into upon exercise.
 Cash settlement, in which case the market value of theCash settlement, in which case the market value of the
underlying swap changes hands upon exercise.underlying swap changes hands upon exercise.

48. Functioning of a SwaptionFunctioning of a Swaption
 The purchaser of the swaption pays an up front premium.The purchaser of the swaption pays an up front premium.
 The fixed rate specified for the swaption plays a role veryThe fixed rate specified for the swaption plays a role very
similar to that of a strike price.similar to that of a strike price.
 The holder of the swaption will decide whether or not toThe holder of the swaption will decide whether or not to
exercise based on whether swap rates rise above or fallexercise based on whether swap rates rise above or fall
below that fixed rate.below that fixed rate.
 For this reason, the fixed rate is often called the strike rate.For this reason, the fixed rate is often called the strike rate.
 If the swaption is exercised, there is no strike price to pay.If the swaption is exercised, there is no strike price to pay.
The two parties simply put on the prescribe swapThe two parties simply put on the prescribe swap

49. Purpose of SwaptionPurpose of Swaption
The primary purposes for entering into aThe primary purposes for entering into a
swaption are:swaption are:
 to hedge call or put positions in bond issues.to hedge call or put positions in bond issues.
 to change the tenor of an underlying swap.to change the tenor of an underlying swap.
 to assist in the engineering of structuredto assist in the engineering of structured
notes.notes.
 to change the payoff profile of the firm.to change the payoff profile of the firm.

50. Types of SwaptionTypes of Swaption
 American SwaptionAmerican Swaption , in which the owner is, in which the owner is
allowed to enter the swap on any day that fallsallowed to enter the swap on any day that falls
within a range of two dates.within a range of two dates.
 Bermudan SwaptionBermudan Swaption , in which the owner is, in which the owner is
allowed to enter the swap on a sequence ofallowed to enter the swap on a sequence of
dates.dates.
 European Swaption,European Swaption, in which the owner isin which the owner is
allowed to enter the swap on one specified dateallowed to enter the swap on one specified date

51. Thank YouThank You