Page 123 - DMGT513_DERIVATIVES_AND_RISK_MANAGEMENT

Derivatives & Risk Management

Notes between two parties in which both parties are 'obligated' to exchange some specified cash flows
at periodic intervals for a fixed period of time. Unlike a forward or a futures contract, a swap
agreement generally involves multiple future points of exchange. The cash flows of a swap may
be fixed in advance, or adjusted for each settlement date by reference to some specified interest
rate, such as LIBOR, or other market yield. On the 'settlement date', a 'difference check' is paid by
whichever party in the swap is obligated to pay more cash than is to be received at the settlement
date.
In general, a swap may be characterized as an agreement between two parties to exchange a
series of cash flows measured by different interest rates, exchange rates, or prices with payments
calculated by reference to a principal base (notional amount). The most common swaps include
currency swaps, in which one currency is exchanged for another at pre-specified terms on one or
more pre-specified dates; and interest rate swaps, in which one type of interest payment (e.g.,
interest payments that float with LIBOR or any other benchmark rate) is exchanged for another
(e.g. fixed interest payments) at one or more pre-specified future dates). In general, swaps can be
divided into three terms i.e., short-term, medium term and long term. Short term swaps have
maturity periods of less than 3 years, medium term swap matures between 3 and 5 years and
long term swaps have a life extending beyond 5 years.

While swaps are used for various purposes-from hedging to speculation-their fundamental
purpose is to change the character of an asset or liability without liquidating that asset or
liability. For example, an investor realising returns from an equity investment can swap those
returns into less risky fixed income cash flows-without having to liquidate the equities. A
corporation with floating rate debt can swap that debt into a fixed rate obligation-without
having to retire and reissue debt. A swap is a cash-settled OTC derivative. Except for forwards,
swaps are the simplest form of OTC derivatives.

Notes Swap Terminology

1. Parties: Generally, there are two parties in a swap deal, and this excludes the
intermediary. For example, in an interest rate swap, the first party could be a fixed
rate payer/receiver and the second party could be a floating rate receiver/payer.
2. Swap Facilitators: Swap facilitators are generally referred to as 'Swap Banks' or
simply 'Banks'. There are two kinds of swaps facilitators i.e., Swap Broker and Swap
Dealer.
3. Swap Broker: Also known as an intermediary, a swap broker as an economic agent
helps in identifying the potential counterparties in a swap deal. The swap broker
only acts as a facilitator charging a commission for his services and does not take
any individual position in the swap contract.
4. Swap Dealer: Swap dealer associates himself with the swap deal and often becomes
an actual party to the transaction. Also known as 'market maker', the swap dealer
may be actively involved as a financial intermediary for earning a profit.
5. Notional Principal: The underlying amount in a swap contract which becomes the
basis for the deal between counterparties is known as the notional principal. It is
called 'notional' because this amount does not vary, but the cash flows in the swap
are attached to this amount. For example, in an interest rate swap, the interest is
calculated on the notional principal.

Contd...

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