Constant maturity swap

From Wikipedia, the free encyclopedia

A constant maturity swap, also known as a CMS, is a swap that allows the purchaser to fix the duration of
received flows on a swap.

The floating leg of an interest rate swap typically resets against a published index. The floating leg of a
constant maturity swap fixes against a point on the swap curve on a periodic basis.

A constant maturity swap is an interest rate swap where the interest rate on one leg is reset periodically, but
with reference to a market swap rate rather than LIBOR. The other leg of the swap is generally LIBOR, but may
be a fixed rate or potentially another constant maturity rate. Constant maturity swaps can either be single
currency or cross currency swaps. Therefore, the prime factor for a constant maturity swap is the shape of the
forward implied yield curves. A single currency constant maturity swap versus LIBOR is similar to a series of
differential interest rate fix (or "DIRF") in the same way that an interest rate swap is similar to a series of
forward rate agreements. Valuation of constant maturity swaps depends on volatilities and correlations of
different forward rates and therefore requires an interest rate model or some approximated methodology like a
convexity adjustment, see for example Brigo and Mercurio (2001).

[edit]Example

A customer believes that the difference between the six-month LIBOR rate will fall relative to the three-year
swap rate for a given currency. To take advantage of this, he buys a constant maturity swap paying the six-
month LIBOR rate and receiving the three-year swap rate.

Credit default swap

From Wikipedia, the free encyclopedia
A credit default swap (CDS) is a swap contract in which the protection buyer of the CDS makes a series of
payments (often referred to as the CDS "fee" or "spread") to the protection seller and, in exchange, receives a
payoff if a credit instrument (typically a bond or loan) experiences a credit event.

In its simplest form, a credit default swap is a bilateral contract between the buyer and seller of protection. The
CDS will refer to a “reference entity" or "reference obligor", usually a corporation or government. The reference
entity is not a party to the contract. The protection buyer makes quarterly premium payments—the “spread”—to
the protection seller. If the reference entity defaults, the protection seller pays the buyer the par value of the
bond in exchange for physical delivery of the bond, although settlement may also be by cash or auction.[1][2] A
default is referred to as a "credit event" and include such events as failure to pay, restructuring and bankruptcy.
[2]
Most CDSs are in the $10–$20 million range with maturities between one and 10 years.[3]

A holder of a bond may “buy protection” to hedge its risk of default. In this way, a CDS is similar to credit
insurance, although CDS are not similar to or subject to regulations governing casualty or life insurance. Also,
investors can buy and sell protection without owning any debt of the reference entity. These “naked credit
default swaps” allow traders to speculate on debt issues and the creditworthiness of reference entities. Credit
default swaps can be used to create synthetic long and short positions in the reference entity.[4] Naked CDS
constitute most of the market in CDS.[5][6] In addition, credit default swaps can also be used in capital structure
arbitrage.

Credit default swaps have existed since the early 1990s, but the market increased tremendously starting in
2003. By the end of 2007, the outstanding amount was $62.2 trillion, falling to $38.6 trillion by the end of 2008.
[7]

Most CDSs are documented using standard forms promulgated by the International Swaps and Derivatives
Association (ISDA), although some are tailored to meet specific needs. Credit default swaps have many
variations.[2] In addition to the basic, single-name swaps, there are basket default swaps (BDS), index CDS,
funded CDS (also called a credit linked notes), as well as loan only credit default swaps (LCDS). In addition to
corporations or governments, the reference entity can include a special purpose vehicle issuing asset backed
securities.[8]

Credit default swaps are not traded on an exchange and there is no required reporting of transactions to a
government agency.[9] During the 2007-2010 financial crisis the lack of transparency became a concern to
regulators, as was the trillion dollar size of the market, which could pose a systemic risk to the economy.[10][2]
[4]
In March 2010, the DTCC Trade Information Warehouse (see Sources of Market Data) announced it would
voluntarily give regulators greater access to its credit default swaps database.[11]

Description
Buyer purchased a CDS at time t0and makes regular premium payments at times t1, t2, t3, and t4. If the associated credit
instrument suffers no credit event, then the buyer continues paying premiums at t5, t6 and so on until the end of the contract
at time tn.

However, if the associated credit instrument suffered a credit event at t5, then the Protection seller pays the buyer for the
loss, and the buyer would cease paying premiums.

A "credit default swap" (CDS) is a credit derivative contract between two counterparties. The buyer makes
periodic payments to the seller, and in return receives a payoff if an underlying financial
instrument defaults or experiences a similar credit event.[1][2][12] The CDS may refer to a specified loan or
bond obligation of a “reference entity”, usually a corporation or government.[3]

As an example, imagine that an investor buys a CDS from AAA-Bank, where the reference entity is Risky
Corp. The investor—the buyer of protection—will make regular payments to AAA-Bank—the seller of
protection. If Risky Corp defaults on its debt, the investor will receive a one-time payment from AAA-Bank,
and the CDS contract is terminated. A default is referred to as a "credit event" and include such events as
failure to pay, restructuring and bankruptcy.[2][9] CDS contracts on sovereign obligations also usually
include as credit events repudiation, moratorium and acceleration.[9]

If the investor actually owns Risky Corp debt, the CDS can be thought of as hedging. But investors can
also buy CDS contracts referencing Risky Corp debt without actually owning any Risky Corp debt. This
may be done for speculative purposes, to bet against the solvency of Risky Corp in a gamble to make
money if it fails, or to hedge investments in other companies whose fortunes are expected to be similar to
those of Risky (see Uses).

If the reference entity (Risky Corp) defaults, one of two kinds of settlement can occur:
 the investor delivers a defaulted asset to AAA-Bank for payment of the par value, which is known
as physical settlement;

 AAA-Bank pays the investor the difference between the par value and the market price of a specified
debt obligation (even if Risky Corp defaults there is usually some recovery, i.e. not all your money will
be lost), which is known as cash settlement.

The "spread" of a CDS is the annual amount the protection buyer must pay the protection seller over the
length of the contract, expressed as a percentage of thenotional amount. For example, if the CDS spread
of Risky Corp is 50 basis points, or 0.5% (1 basis point = 0.01%), then an investor buying $10 million
worth of protection from AAA-Bank must pay the bank $50,000 per year. These payments continue until
either the CDS contract expires or Risky Corp defaults. Payments are usually made on a quarterly basis,
in arrears.

Credit default swaps are not retail transactions. Most CDS’s are in the $10–20 million range with
maturities between one and 10 years.[3] Five years is the most typical maturity.[8]

All things being equal, at any given time, if the maturity of two credit default swaps is the same, then the
CDS associated with a company with a higher CDS spread is considered more likely to default by the
market, since a higher fee is being charged to protect against this happening. However, factors such as
liquidity and estimated loss given default can affect the comparison. Credit spread rates and credit ratings
of the underlying or reference obligations are considered among money managers to be the best
indicators of the likelihood of sellers of CDSs having to perform under these contracts.[2]

Currency swap
From Wikipedia, the free encyclopedia

Foreign exchange

Exchange rates

Currency band

Exchange rate

Exchange rate regime

Fixed exchange rate

Floating exchange rate

Linked exchange rate

Markets
 Foreign exchange market

Futures exchange

Retail forex

Products

Currency

Currency future

Non-deliverable forward

Forex swap

Currency swap

Foreign exchange option

See also

Bureau de change / currency exchange

(office)

A currency swap is a foreign-exchange agreement between two parties to exchange aspects (namely
the principal and/or interest payments) of a loan in one currency for equivalent aspects of an equal in net
present value loan in another currency; see Foreign exchange derivative. Currency swaps are motivated
bycomparative advantage.[1] A currency swap should be distinguished from a central bank liquidity swap.

Contents
[hide]

• 1 Structure

• 2 Uses

○ 2.1 Hed

ging

Example

• 3 History

• 4 References

[edit]Structure

Currency swaps are over-the-counter derivatives, and are closely related to interest rate swaps. However,
unlike interest rate swaps, currency swaps can involve the exchange of the principal.[1]

There are three different ways in which currency swaps can exchange loans:
The most simple currency swap structure is to exchange the principal only with the counterparty, at a rate
agreed now, at some specified point in the future. Such an agreement performs a function equivalent to
a forward contract or futures. The cost of finding a counterparty (either directly or through an intermediary), and
drawing up an agreement with them, makes swaps more expensive than alternative derivatives (and thus rarely
used) as a method to fix shorter term forward exchange rates. However for the longer term future, commonly
up to 10 years, where spreads are wider for alternative derivatives, principal-only currency swaps are often
used as a cost-effective way to fix forward rates. This type of currency swap is also known as an FX-swap.[2]

Another currency swap structure is to combine the exchange of loan principal, as above, with an interest rate
swap. In such a swap, interest cash flows are not netted before they are paid to the counterparty (as they
would be in a vanilla interest rate swap) because they are denominated in different currencies. As each party
effectively borrows on the other's behalf, this type of swap is also known as a back-to-back loan.[2]

Last here, but certainly not least important, is to swap only interest payment cash flows on loans of the same
size and term. Again, as this is a currency swap, the exchanged cash flows are in different denominations and
so are not netted. An example of such a swap is the exchange of fixed-rate US Dollar interest payments
for floating-rate interest payments in Euro. This type of swap is also known as a cross-currency interest rate
swap, or cross-currency swap.[3]

[edit]Uses

Currency swaps have two main uses:

 To secure cheaper debt (by borrowing at the best available rate regardless of currency and then swapping
for debt in desired currency using a back-to-back-loan).[2]

 To hedge against (reduce exposure to) exchange rate fluctuations.[2]

[edit]Hedging Example
For instance, a US-based company needing to borrow Swiss Francs, and a Swiss-based company needing to
borrow a similar present value in US Dollars, could both reduce their exposure to exchange rate fluctuations by
arranging any one of the following:

 If the companies have already borrowed in the currencies each needs the principal in, then exposure is
reduced by swapping cash flows only, so that each company's finance cost is in that company's domestic
currency.

 Alternatively, the companies could borrow in their own domestic currencies (and may well each
have comparative advantage when doing so), and then get the principal in the currency they desire with a
principal-only swap.
[edit]History
Currency swaps were originally conceived in the 1970s to circumvent foreign exchange controls in the United
Kingdom. At that time, UK companies had to pay a premium to borrow in US Dollars. To avoid this, UK
companies set up back-to-back loan agreements with US companies wishing to borrow Sterling.[4] While such
restrictions on currency exchange have since become rare, savings are still available from back-to-back loans
due to comparative advantage.

Cross-currency interest rate swaps were introduced by the World Bank in 1981 to obtain Swiss francs and
German marks by exchanging cash flows with IBM. This deal was brokered by Salomon Brothers with
a notional amount of $210 million dollars and a term of over ten years.[5]

During the global financial crisis of 2008, the currency swap transaction structure was used by the United
States Federal Reserve System to establish central bank liquidity swaps. In these, the Federal Reserve and the
central bank of a developed[6] or stable emerging[7] economy agree to exchange domestic currencies at the
current prevailing market exchange rate & agree to reverse the swap at the same exchange rate at a fixed
future date. The aim of central bank liquidity swaps is "to provide liquidity in U.S. dollars to overseas
markets."[8] While central bank liquidity swaps and currency swaps are structurally the same, currency swaps
are commercial transactions driven by comparative advantage, while central bank liquidity swaps are
emergency loans of US Dollars to overseas markets, and it is currently unknown whether or not they will be
beneficial for the Dollar or the US in the long-term.[9]

The People's Republic of China has multiple year currency swap agreements of
the Renminbi with Argentina, Belarus, Hong Kong, Iceland, Indonesia, Malaysia, Singapore, and South
Korea that perform a similar function to central bank liquidity swaps.[10]

[edit]References

1. ^ a b http://www.finpipe.com/currswaps.htm

2. ^ a b c d Financial Management Study Manual - ICAEW (second ed.). Institute of Chartered Accountants in
England & Wales (Milton Keynes). 2008 [2007]. pp. 462–3. ISBN 978-1-84152-569-3.

3. ^ http://www.isda.org/educat/faqs.html#22

4. ^ http://books.google.co.uk/books?id=YDiHUIQk3C4C&pg=PA24

5. ^ http://faculty.london.edu/ruppal/zenSlides/zCH10%20Swaps.slide.doc

6. ^ http://www.federalreserve.gov/newsevents/press/monetary/20081029b.htm

7. ^ Chan, Fiona (2008-10-31). "Fed swap line for S'pore". The Straits Times. Retrieved 2008-10-31.

8. ^ http://www.federalreserve.gov/monetarypolicy/bst_liquidityswaps.htm

9. ^ http://www.moslereconomics.com/2009/04/13/fed-foreign-currency-swap-lines/
 10. ^ http://www.chinadaily.com.cn/china/2009-03/31/content_7635007.htm

[hide]

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 Equity swap

An equity swap is a financial derivative contract (a swap) where a set of future cash flows are agreed to
be exchanged between two counterparties at set dates in the future. The two cash flows are usually
referred to as "legs" of the swap; one of these "legs" is usually pegged to a floating rate such as LIBOR.
This leg is also commonly referred to as the "floating leg". The other leg of the swap is based on the
performance of either a share of stock or a stock market index. This leg is commonly referred to as the
"equity leg". Most equity swaps involve a floating leg vs. an equity leg, although some exist with two
equity legs.

• An equity swap involves a notional principal, a specified tenor and predetermined payment
intervals.

• Equity swaps are typically traded by Delta One trading desks.

• [edit]Examples

• Parties may agree to make periodic payments or a single payment at the maturity of the swap
("bullet" swap), the worst case.

• Take a simple index swap where Party A swaps £5,000,000 at LIBOR + 0.03% (also
called LIBOR + 3 basis points) against £5,000,000 (FTSE to the £5,000,000 notional). In this
case Party A will pay (to Party B) a floating interest rate (LIBOR +0.03%) on the £5,000,000
notional and would receive from Party B any percentage increase in the FTSE equity index
applied to the £5,000,000 notional.

• In this example, assuming a LIBOR rate of 5.97% p.a. and a swap tenor of precisely 180 days,
the floating leg payer/equity receiver (Party A) would owe (5.97%+0.03%)*£5,000,000*180/360 =
£150,000 to the equity payer/floating leg receiver (Party B).

• At the same date (after 180 days) if the FTSE had appreciated by 10% from its level at trade
commencement, Party B would owe 10%*£5,000,000 = £500,000 to Party A. If, on the other
hand, the FTSE at the six-month mark had fallen by 10% from its level at trade commencement,
Party A would owe an additional 10%*£5,000,000 = £500,000 to Party B, since the flow is
negative.

• For mitigating credit exposure, the trade can be reset, or "marked-to-market" during its life. In that
case, appreciation or depreciation since the last reset is paid and the notional is increased by any
payment to the pricing rate payer or decreased by any payment from the floating leg payer.

• [edit]Applications
• Typically Equity Swaps are entered into in order to avoid transaction costs (including Tax), to
avoid locally based dividend taxes, limitations on leverage (notably the US margin regime) or to
get around rules governing the particular type of investment that an institution can hold.

• Equity Swaps also provide the following benefits over plain vanilla equity investing:

• 1. An investor in a physical holding of shares loses possession on the shares once he sells his
position. However, using an equity swap the investor can pass on the negative returns on equity
position without losing the possession of the shares and hence voting rights. For example, let's
say A holds 100 shares of a Petroleum Company. As the price of crude falls the investor believes
the stock would start giving him negative returns in the short run. However, his holding gives him
a strategic voting right in the board which he does not want to lose. Hence, he enters into an
equity swap deal wherein he agrees to pay Party B the return on his shares against
LIBOR+25bps on a notional amt. If A is proven right, he will get money from B on account of the
negative return on the stock as well as LIBOR+25bps on the notional. Hence, he mitigates the
negative returns on the stock without losing on voting rights.

• 2. It allows an investor to receive the return on a security which is listed in such a market where
he cannot invest due to legal issues. For example, let's say A wants to invest on script X listed in
Country C. However, A is not allowed to invest in Country C due to capital control regulations. He
can however, enter into a contract with B, who is a resident of C, and ask him to buy the shares
of company X and provide him with the return on share X and he agrees to pay him a fixed /
floating rate of return.

• Equity Swaps, if effectively used, can make investment barriers vanish and help an investor
create leverage similar to those seen in derivative products.

• Investment banks that offer this product usually take a riskless position by hedging the client's
position with the underlying asset. For example, the client may trade a swap - say Vodafone. The
bank credits the client with 1,000 Vodafone at GBP1.45. The bank pays the return on this
investment to the client, but also buys the stock in the same quantity for its own trading book
(1,000 Vodafone at GBP1.45). Any equity-leg return paid to or due from the client is offset against
realised profit or loss on its own investment in the underlying asset. The bank makes its money
through commissions, interest spreads and dividend rake-off (paying the client less of the
dividend than it receives itself). It may also use the hedge position stock (1,000 Vodafone in this
example) as part of a funding transaction such as stock lending,repo or as collateral for a loan.

---------------------------------------------------------------------------------------------------------------
Forex swap
From Wikipedia, the free encyclopedia
Foreign exchange

Exchange rates

Currency band

Exchange rate

Exchange rate regime

Fixed exchange rate

Floating exchange rate

Linked exchange rate

Markets

Foreign exchange market

Futures exchange

Retail forex

Products

Currency

Currency future

Non-deliverable forward

Forex swap

Currency swap

Foreign exchange option

See also

Bureau de change / currency exchange

(office)

In finance, a forex swap (or FX swap) is a simultaneous purchase and sale of identical amounts of one
currency for another with two different value dates (normally spot to forward).[1]; see Foreign exchange
derivative.

Contents
[hide]

• 1 Structure

• 2 Uses
 • 3 Pricing

• 4 Related

instruments

• 5 See also

• 6 References

[edit]Structure

A forex swap consists of two legs:

 a spot foreign exchange transaction, and

 a forward foreign exchange transaction.

These two legs are executed simultaneously for the same quantity, and therefore offset each other.

It is also common to trade forward-forward, where both transactions are for (different) forward dates.

[edit]Uses

By far and away the most common use of FX swaps is for institutions to fund their foreign exchange balances.

Once a foreign exchange transaction settles, the holder is left with a positive (or long) position in one currency,
and a negative (or short) position in another. In order to collect or pay any overnight interest due on these
foreign balances, at the end of every day institutions will close out any foreign balances and re-institute them
for the following day. To do this they typically use tom-next swaps, buying (selling) a foreign amount settling
tomorrow, and selling (buying) it back settling the day after.

The interest collected or paid every night is referred to as the cost of carry. As currency traders know roughly
how much holding a currency position will make or cost on a daily basis, specific trades are put on based on
this; these are referred to as carry trades.

[edit]Pricing

The relationship between spot and forward is as follows:

where:

 F = forward rate

 S = spot rate
  r1 = simple interest rate of the term currency

 r2 = simple interest rate of the base currency

 T = tenor (calculated according to the appropriate day count convention)

The forward points or swap points are quoted as the difference between forward and spot, F - S, and is
expressed as the following:

where r1 and r2 are small. Thus, the absolute value of the swap points increases when the interest
rate differential gets larger, and vice versa.

[edit]Related instruments

A forex swap should not be confused with a currency swap, which is a much rarer, long term
transaction, governed by a slightly different set of rules

[edit]See also

Interest rate swap

From Wikipedia, the free encyclopedia

A swap is a derivative in which one party exchanges a stream of interest payments for another party's stream
of cash flows. Interest rate swaps can be used by hedgers to manage their fixed orfloating assets and liabilities.
They can also be used by speculators to replicate unfunded bond exposures to profit from changes in interest
rates. Interest rate swaps are very popular and highly liquid instruments.

Contents
[hide]

• 1 Structure

• 2 Types

○ 2.1 Fixed-for-floating rate swap,

same currency

○ 2.2 Fixed-for-floating rate swap,

different currencies

○ 2.3 Floating-for-floating rate swap,

same currency
 ○ 2.4 Floating-for-floating rate swap,

different currencies

○ 2.5 Fixed-for-fixed rate swap,

different currencies

○ 2.6 Other variations

• 3 Uses

○ 3.1 Speculation

○ 3.2 LIBOR/Swap zero rate

○ 3.3 British local authorities

• 4 Valuation and pricing

• 5 Risks

• 6 Market size

• 7 References

• 8 See also

• 9 External links

[edit]Structure
A is currently paying floating, but wants to pay fixed. B is currently paying fixed but wants to pay floating. By entering into an
interest rate swap, the net result is that each party can 'swap' their existing obligation for their desired obligation.

In an interest rate swap, each counterparty agrees to pay either a fixed or floating rate denominated in a
particular currency to the other counterparty. The fixed or floating rate is multiplied by a notional principal
amount (say, USD 1 million). This notional amount is generally not exchanged between counterparties, but is
used only for calculating the size of cashflows to be exchanged.

The most common interest rate swap is one where one counterparty A pays a fixed rate (the swap rate) to
counterparty B, while receiving a floating rate (usually pegged to a reference rate such as LIBOR).

A pays fixed rate to B (A receives variable rate)

B pays variable rate to A (B receives fixed rate).

Consider the following swap in which Party A agrees to pay Party B periodic fixed interest rate payments of
8.65%, in exchange for periodic variable interest rate payments of LIBOR + 70 bps (0.70%). Note that there is
no exchange of the principal amounts and that the interest rates are on a "notional" (i.e. imaginary) principal
amount. Also note that the interest payments are settled in net (e.g. Party A pays (LIBOR + 1.50%)+8.65% -
(LIBOR+0.70%) = 9.45% net. The fixed rate (8.65% in this example) is referred to as the swap rate.[1]

At the point of initiation of the swap, the swap is priced so that it has a net present value of zero. If one party
wants to pay 50 bps above the par swap rate, the other party has to pay approximately 50 bps over LIBOR to
compensate for this.

[edit]Types

Normally the parties do not swap payments directly, but rather each sets up a separate swap with a financial intermediary
such as a bank. In return for matching the two parties together, the bank takes a spread from the swap payments (in this
case 0.30% compared to the above example)
Being OTC instruments interest rate swaps can come in a huge number of varieties and can be structured to
meet the specific needs of the counterparties. By far the most common are fixed-for-floating, fixed-for-fixed or
floating-for-floating. The legs of the swap can be in the same currency or in different currencies. (A single-
currency fixed-for-fixed rate swap is generally not possible; since the entire cash-flow stream can be predicted
at the outset there would be no reason to maintain a swap contract as the two parties could just settle for the
difference between the present values of the two fixed streams; the only exceptions would be where the
notional amount on one leg is uncertain or other esoteric uncertainty is introduced).

[edit]Fixed-for-floating rate swap, same currency

Party B pays/receives fixed interest in currency A to receive/pay floating rate in currency A indexed to X on a
notional amount N for a term of T years. For example, you pay fixed 5.32% monthly to receive USD
1M Libor monthly on a notional USD 1 million for 3 years. The party that pays fixed and receives floating
coupon rates is said to be short the interest swap because it is expressed as a bond convention (as prices fall,
yields rise). Interest rate swaps are simply the exchange of one set of cash flows for another.

Fixed-for-floating swaps in same currency are used to convert a fixed rate asset/liability to a floating rate
asset/liability or vice versa. For example, if a company has a fixed rate USD 10 million loan at 5.3% paid
monthly and a floating rate investment of USD 10 million that returns USD 1M Libor +25 bps monthly, it may
enter into a fixed-for-floating swap. In this swap, the company would pay a floating rate of USD 1M Libor+25
bps and receive a 5.5% fixed rate, locking in 20bps profit.

[edit]Fixed-for-floating rate swap, different currencies

Party P pays/receives fixed interest in currency A to receive/pay floating rate in currency B indexed to X on a
notional N at an initial exchange rate of FX for a tenure of T years. For example, you pay fixed 5.32% on the
USD notional 10 million quarterly to receive JPY 3M (TIBOR) monthly on a JPY notional 1.2 billion (at an initial
exchange rate of USD/JPY 120) for 3 years. For nondeliverable swaps, the USD equivalent of JPY interest will
be paid/received (according to the FX rate on the FX fixing date for the interest payment day). No initial
exchange of the notional amount occurs unless the Fx fixing date and the swap start date fall in the future.

Fixed-for-floating swaps in different currencies are used to convert a fixed rate asset/liability in one currency to
a floating rate asset/liability in a different currency, or vice versa. For example, if a company has a fixed rate
USD 10 million loan at 5.3% paid monthly and a floating rate investment of JPY 1.2 billion that returns JPY 1M
Libor +50 bps monthly, and wants to lock in the profit in USD as they expect the JPY 1M Libor to go down or
USDJPY to go up (JPY depreciate against USD), then they may enter into a Fixed-Floating swap in different
currency where the company pays floating JPY 1M Libor+50 bps and receives 5.6% fixed rate, locking in 30bps
profit against the interest rate and the fx exposure.
[edit]Floating-for-floating rate swap, same currency
Party P pays/receives floating interest in currency A Indexed to X to receive/pay floating rate in currency A
indexed to Y on a notional N for a tenure of T years. For example, you pay JPY 1M LIBOR monthly to receive
JPY 1M TIBOR monthly on a notional JPY 1 billion for 3 years.

Floating-for-floating rate swaps are used to hedge against or speculate on the spread between the two indexes
widening or narrowing. For example, if a company has a floating rate loan at JPY 1M LIBOR and the company
has an investment that returns JPY 1M TIBOR + 30 bps and currently the JPY 1M TIBOR = JPY 1M LIBOR +
10bps. At the moment, this company has a net profit of 40 bps. If the company thinks JPY 1M TIBOR is going
to come down (relative to the LIBOR) or JPY 1M LIBOR is going to increase in the future (relative to the
TIBOR) and wants to insulate from this risk, they can enter into a float-float swap in same currency where they
pay, say, JPY TIBOR + 30 bps and receive JPY LIBOR + 35 bps. With this, they have effectively locked in a 35
bps profit instead of running with a current 40 bps gain and index risk. The 5 bps difference (w.r.t. the current
rate difference) comes from the swap cost which includes the market expectations of the future rate difference
between these two indices and the bid/offer spread which is the swap commission for the swap dealer.

Floating-for-floating rate swaps are also seen where both sides reference the same index, but on different
payment dates, or use different business day conventions. These have almost no use for speculation, but can
be vital for asset-liability management. An example would be swapping 3M LIBOR being paid with prior non-
business day convention, quarterly on JAJO (i.e. Jan, Apr, Jul, Oct) 30, into FMAN (i.e. Feb, May, Aug, Nov) 28
modified following・

[edit]Floating-for-floating rate swap, different currencies

Party P pays/receives floating interest in currency A indexed to X to receive/pay floating rate in currency B
indexed to Y on a notional N at an initial exchange rate of FX for a tenure of T years. For example, you pay
floating USD 1M LIBOR on the USD notional 10 million quarterly to receive JPY 3M TIBOR monthly on a JPY
notional 1.2 billion (at an initial exchange rate of USDJPY 120) for 4 years.

To explain the use of this type of swap, consider a US company operating in Japan. To fund their Japanese
growth, they need JPY 10 billion. The easiest option for the company is to issue debt in Japan. As the company
might be new in the Japanese market without a well known reputation among the Japanese investors, this can
be an expensive option. Added on top of this, the company might not have appropriate debt issuance program
in Japan and they might lack sophisticated treasury operation in Japan. To overcome the above problems, it
can issue USD debt and convert to JPY in the FX market. Although this option solves the first problem, it
introduces two new risks to the company:

 FX risk. If this USDJPY spot goes up at the maturity of the debt, then when the company converts the JPY
to USD to pay back its matured debt, it receives less USD and suffers a loss.
 USD and JPY interest rate risk. If the JPY rates come down, the return on the investment in Japan might
go down and this introduces an interest rate risk component.

The first exposure in the above can be hedged using long dated FX forward contracts but this introduces a new
risk where the implied rate from the FX spot and the FX forward is a fixed rate but the JPY investment returns a
floating rate. Although there are several alternatives to hedge both the exposures effectively without introducing
new risks, the easiest and the most cost effective alternative would be to use a floating-for-floating swap in
different currencies. In this, the company raises USD by issuing USD Debt and swaps it to JPY. It receives
USD floating rate (so matching the interest payments on the USD Debt) and pays JPY floating rate matching
the returns on the JPY investment.

[edit]Fixed-for-fixed rate swap, different currencies

Party P pays/receives fixed interest in currency A to receive/pay fixed rate in currency B for a term of T years.
For example, you pay JPY 1.6% on a JPY notional of 1.2 billion and receive USD 5.36% on the USD equivalent
notional of 10 million at an initial exchange rate of USDJPY 120.

[edit]Other variations
A number of other variations are possible, although far less common. Mostly tweaks are made to ensure that a
bond is hedged "perfectly", so that all the interest payments received are exactly offset by the swap. This can
lead to swaps where principal is paid on one or more legs, rather than just interest (for example to hedge a
coupon strip), or where the balance of the swap is automatically adjusted to match that of a prepaying bond
(such as RMBS Residential mortgage-backed security)

[edit]Uses

Interest rate swaps were originally created to allow multi-national companies to evade exchange controls.
Today, interest rate swaps are used to hedge against or speculate on changes in interest rates.

[edit]Speculation

Interest rate swaps are also used speculatively by hedge funds or other investors who expect a change in
interest rates or the relationships between them. Traditionally, fixed income investors who expected rates to fall
would purchase cash bonds, whose value increased as rates fell. Today, investors with a similar view could
enter a floating-for-fixed interest rate swap; as rates fall, investors would pay a lower floating rate in exchange
for the same fixed rate.

Interest rate swaps are also very popular due to the arbitrage opportunities they provide. Due to varying levels
of creditworthiness in companies, there is often a positive quality spread differential which allows both parties to
benefit from an interest rate swap.
The interest rate swap market is closely linked to the Eurodollar futures market which trades at the Chicago
Mercantile Exchange.

[edit]LIBOR/Swap zero rate

Since LIBOR only has maturities out to 12 months, and since interest rate swaps often use LIBOR as the
reference rate, interest rate swaps can be used as a proxy to extend the LIBOR yield curveout past 12 months.

[edit]British local authorities

In June 1988 the Audit Commission was tipped off by someone working on the swaps desk of Goldman
Sachs that the London Borough of Hammersmith and Fulham had a massive exposure to interest rate swaps.
When the commission contacted the council, the chief executive told them not to worry as "everybody knows
that interest rates are going to fall"; the treasurer thought the interest rate swaps were a 'nice little earner'. The
controller of the commission, Howard Davies realised that the council had put all of its positions on interest
rates going down; he sent a team in to investigate.

By January 1989 the commission obtained legal opinions from two Queen's Counsel. Although they did not
agree, the commission preferred the opinion which made it ultra vires for councils to engage in interest rate
swaps. Moreover interest rates had gone up from 8% to 15%. The auditor and the commission then went to
court and had the contracts declared illegal (appeals all the way up to theHouse of Lords failed); the five banks
involved lost millions of pounds. Many other local authorities had been engaging in interest rate swaps in the
1980s, although Hammersmith was unusual in betting all one way.[2]

[edit]Valuation and pricing

Further information: Rational_pricing#Swaps

The present value of a plain vanilla (i.e. fixed rate for floating rate) swap can easily be computed using
standard methods of determining the present value (PV) of the fixed leg and the floating leg.

The value of the fixed leg is given by the present value of the fixed coupon payments known at the start of the
swap, i.e.

where C is the swap rate, M is the number of fixed payments, P is the notional amount, ti is the number of
days in period i, Ti is the basis according to the day count convention and dfi is the discount factor.

Similarly, the value of the floating leg is given by the present value of the floating coupon payments
determined at the agreed dates of each payment. However, at the start of the swap, only the actual
payment rates of the fixed leg are known in the future, whereas the forward rates (derived from the yield
curve) are used to approximate the floating rates. Each variable rate payment is calculated based on the
forward rate for each respective payment date. Using these interest rates leads to a series of cash flows.
Each cash flow is discounted by the zero-coupon rate for the date of the payment; this is also sourced
from the yield curve data available from the market. Zero-coupon rates are used because these rates are
for bonds which pay only one cash flow. The interest rate swap is therefore treated like a series of zero-
coupon bonds. Thus, the value of the floating leg is given by the following:

where N is the number of floating payments, fj is the forward rate, P is the notional amount, tj is the
number of days in period j, Tj is the basis according to the day count convention and dfj is the
discount factor. The discount factor always starts with 1. The discount factor is found as follows:

[Discount factor in the previous period]/[1 + (Forward rate of the floating underlying asset in the
previous period × Number of days in period/360)].

(Depending on the currency, the denominator is 365 instead of 360; e.g. for GBP.)

The fixed rate offered in the swap is the rate which values the fixed rates payments at the
same PV as the variable rate payments using today's forward rates, i.e.:

[3]

Therefore, at the time the contract is entered into, there is no advantage to either party,
i.e.,

Thus, the swap requires no upfront payment from either party.

During the life of the swap, the same valuation technique is used, but since, over
time, the forward rates change, the PV of the variable-rate part of the swap will
deviate from the unchangeable fixed-rate side of the swap. Therefore, the swap
will be an asset to one party and a liability to the other. The way these changes in
value are reported is the subject of IAS 39 for jurisdictions following IFRS,
and FAS 133 for U.S. GAAP. Swaps are marked to market by debt security traders
to visualize their inventory at a certain time.
[edit]Risks

Interest rate swaps expose users to interest rate risk and credit risk.

 Interest rate risk originates from changes in the floating rate. In a plain vanilla
fixed-for-floating swap, the party who pays the floating rate benefits when
rates fall. (Note that the party that pays floating has an interest rate exposure
analogous to a long bond position.)

 Credit risk on the swap comes into play if the swap is in the money or not. If
one of the parties is in the money, then that party faces credit risk of possible
default by another party.
[edit]Market size

The Bank for International Settlements reports that interest rate swaps are the
second largest component of the global OTC derivative market. The notional
amount outstanding as of June 2009 in OTC interest rate swaps was $342 trillion,
up from $310 trillion in Dec 2007. The gross market value was $13.9 trillion in
June 2009, up from $6.2 trillion in Dec 2007.

Interest rate swaps can now be traded as an Index through the FTSE MTIRS
Index.

[edit]References

1. ^ "Interest Rate Swap" by Fiona Maclachlan, The Wolfram

Demonstrations Project.

2. ^ Duncan Campbell-Smith, "Follow the Money: The Audit Commission,

Public Money, and the Management of Public Services 1983-2008", Allen
Lane, 2008, chapter 6 passim.

3. ^ "Understanding interest rate swap math & pricing". California Debt and
Investment Advisory Commission. 2007-01. Retrieved 2007-09-27.

 Pricing and Hedging Swaps, Miron P. & Swannell P., Euromoney books 1991
[edit]See also

Total return swap

 total return swap, or TRS (especially in Europe), or total rate of return swap, or TRORS, is a
financial contract which transfers both thecredit risk and market risk of an underlying asset.

Contents
[hide]

• 1 Contract definition

• 2 Advantage of using Total

Rate Swaps

• 3 Users

• 4 References

• 5 External links

• 6 See also

[edit]Contract definition
Let us assume that one bank (bank A) owns an asset (e.g. a bond) which periodically gives interest rate
payments. Assume that bank A (the protection buyer) and bank B (the protection seller) have entered
a total return swap contract. According to this contract, bank A is paying all interest payments on the
reference asset, plus any capital gains (positive price changes of the asset) over the payment period to
bank B. Furthermore, bank B is paying LIBOR plus a spread as well as any negative price changes of the
asset. In case of a default of the underlying asset, the asset is valued to zero and bank B has to pay the
full initial market price of the asset (which was valid at the start of the contract).

The reference asset may be any asset, index, or basket of assets. TRORS are particularly popular on
bank loans, which do not have a liquid repo market.

[edit]Advantage of using Total Rate Swaps

The TRORS allows one party to derive the economic benefit of owning an asset without putting that asset
on its balance sheet, and allows the other (which does retain that asset on its balance sheet) to buy
protection against loss in its value.[1]

A similar situation is if bank A gives bank B a loan used to finance the transfer of ownership of the
underlying asset from bank A to bank B. In this case bank B gets the same capital flows as in the case of
a total rate swap (with indefinite contract length). Here the underlying asset is used as collateral for the
loan. The use of a total rate swap in this situation is advantageous to bank A, because the bank has no
potential legal problems selling the underlying asset (because this asset is in the ownership of the bank).
[2]
TRORS can be categorised as a type of credit derivative, although the product combines both market
risk and credit risk, and so is not a pure credit derivative.

When loans are structured as a “total return swap” — the lending party's claims will not be stayed along
with other creditors’ if the borrowing party files for Chapter 11 bankruptcy. The lender can extract
payments it is owed outside of the normal bankruptcy process.[3]

[edit]Users

Hedge funds are using Total Return Swaps to obtain leverage on the Reference Assets: they can receive
the return of the asset, typically from a bank (which has a funding cost advantage), without having to put
out the cash to buy the Asset. They usually post a smaller amount of collateral upfront, thus obtaining
leverage.

Hedge funds (such as The Children's Investment Fund (TCI)) have attempted to use Total Return Swaps
to side-step public disclosure requirements enacted under the Williams Act. As discussed in CSX Corp. v.
The Children's Investment Fund Management, TCI argued that it was not the beneficial owner of the
shares referenced by its Total Return Swaps and therefore the swaps did not require TCI to publicly
disclose that it had acquired a stake of more than 5% in CSX. The United States District Court rejected
this argument.[4]

Total Return Swaps are also very common in many structured finance transactions such as Collateralized
Debt Obligations (CDOs). CDO Issuers often enter TRS agreements as protection seller in order to
leverage the returns for the structure's debt investors. By selling protection, the CDO gains exposure to
the underlying asset(s) without having to put up capital to purchase the assets outright. The CDO gains
the interest receivable on the reference asset(s) over the period while the counterparty mitigates their
market of risk.

[edit]References

1. ^ Dufey, Gunter; Rehm, Florian (2000). An Introduction to Credit Derivatives (Teaching Note).
Retrieved 2008-09-03.

2. ^ Hull, John C. (2006). Options, Futures, and other derivatives, 6th Edition., page 516

3. ^ Winkler, Rolfe (2009). "Why privilege derivatives?". Retrieved 2009-10-06.

4. ^ 562 F.Supp.2d 511 (S.D.N.Y. 2008), see also

[edit]External links
 Total Return Swap article on Financial-edu.com