Plain Vanilla Interest Rate Swap
A plain vanilla interest rate swap exchanges floating-rate payments (LIBOR) for fixed-rate payments over the life of the swap. The floating rate payments at time t in a plain vanilla interest rate swap are computed using the floating rate at time t − 1.
Interest rate swaps can be combined with existing asset and liability positions to drastically change the interest rate risk.
Financial Intermediaries
A swap dealer or financial intermediary facilitates the ability to enter into swaps.
Confirmations outline the details of each swap agreement. A representative of each party signs the confirmation, ensuring that they agree with all swap details and the steps taken in the event of default.
Comparative Advantage
The comparative advantage argument suggests that when one of two borrowers has a comparative advantage in either the fixed- or floating-rate market, both borrowers will be better off by entering into a swap to exploit the advantage. The comparative advantage argument is flawed in that it assumes rates can be borrowed for the life of the swap. It also ignores the credit risk associated with the swap that does not exist if funds were raised directly in the capital markets.
The Discount Rate
Since a swap is nothing more than a sequence of cash flows, its value is determined by discounting each cash flow back to the valuation date. The cash flows are discounted using the corresponding spot rate from the LIBOR spot curve.
Valuing an Interest Rate Swap With Bonds
The value of a swap to the fixed-rate receiver at a point in time is the difference between the present value of the remaining fixed-rate payments and the present value of the remaining floating-rate payments.
Valuing an Interest Rate Swap With FRAs
Valuing a swap based on a sequence of forward rate agreements (FRAs) produces the same result as valuing a swap based on two simultaneous bond positions.
Currency Swaps
A currency swap exchanges interest rate payments in two different currencies. The exchange rate used in currency swaps is the spot exchange rate.
Currency swaps can be combined with existing positions to completely alter the risk of a liability or an asset.
In addition to valuing a currency swap based on two simultaneous bond positions, the value of a currency swap can also be calculated based on a sequence of FRAs.
Since the principals in a currency swap are not the same currency, they are exchanged at the inception of the currency swap so that they have equal value using the spot exchange rate. Also, the periodic cash flows throughout the swap are not netted as they are in an interest rate swap.
Swap Credit Risk
Credit risk is an important factor in existing swap positions, although potential losses are usually smaller than that with debt agreements.
Commodity, Volatility, and Exotic Swaps
Many different types of swaps exist. Examples of swaps, in addition to interest rate swaps and currency swaps, include: equity swaps, commodity swaps, and volatility swaps.
