Page 124 - DMGT513_DERIVATIVES_AND_RISK_MANAGEMENT

Unit 9: Swaps

6. Trade Date: The date on which both the parties in a swap deal enter into the contract Notes
is known as trade date.
7. Effective Date: It is also known as Value Date: This is the date when the initial cash
flows in a swap contract begin (e.g. initial fixed and floating payments, for interest
rate swaps). The maturity of a swap contract is calculated from this date.

8. Reset Date: Reset date is that date on which the LIBOR rate is determined. The first
reset date will be generally two days before the first payment date and the second
reset date will be two days before the second payment date and so on.
9. Maturity Date: The date on which the outstanding cash flows stop in the swap
contract is referred to as the maturity date.

9.1.1 Features of Swaps

Swap is a combination of forwards by two counterparties. It is arranged to reap the benefits
arising from the fluctuations in the market – either currency market or interest rate market or
any other market for that matter.

The following are the important features of a swap:
1. Basically a forward: A swap is nothing but a combination of forwards. So, it has all the
properties of forward contract.

2. Double coincidence of wants: Swap requires that two parties with equal and opposite
needs must come into contact with each other. i.e., rate of interest differs from market to
market and within the market itself. It varies from borrowers to borrowers due to relative
credit worthiness of borrowers.

3. Comparative Credit Advantage: Borrowers enjoying comparative credit advantage in
floating rate debts will enter into a swap agreement to exchange floating rate interest with
the borrowers enjoying comparative advantage in fixed interest rate debt, like bonds. In
the bond market, lending is done at a fixed rate for a long duration, and therefore the
lenders do not have the opportunity to adjust the interest rate according to the situation
prevailing in the market.
4. Flexibility: In short-term market, the lenders have the flexibility to adjust the floating
interest rate (short-term rate) according to the conditions prevailing in the market as well
as the current financial position of the borrower. Hence, the short-term floating interest
rate is cheaper to the borrower with low credit rating when compared with fixed rate of
interest.

5. Necessity of an Intermediary: Swap requires the existence of two counterparties with
opposite but matching needs. This has created a necessity for an intermediary to cancel
both the parties. By arranging swaps, these intermediaries can earn income too. Financial
companies, particularly banks, can play a key role in this innovative field by virtue of
their special position in the financial market and their knowledge of the diverse needs of
the customers.
6. Settlements: Through a specified principal amount is mentioned in the swap agreement;
there is no exchange of principal. On the other hand, a stream of fixed rate interest is
exchanged for a floating rate of interest, and thus, there are streams of cash flows rather
than single payment.
7. Long-term agreement: Generally, forwards are arranged for short period only. Long dated
forward rate contracts are not preferred because they involve more risks like risk of

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