Page 125 - DMGT513_DERIVATIVES_AND_RISK_MANAGEMENT

Derivatives & Risk Management

Notes default, risk of interest rate fluctuations etc. But, swaps are in the nature of long-term
agreement and they are just like long dated forward rate contracts. The exchange of a fixed
rate for a floating rate requires a comparatively longer period.

9.1.2 Uses of Swaps

Treasurers use swaps to hedge against rising interest rates and to reduce borrowing costs.
Among other applications, swaps give financial managers the ability to:
1. convert floating rate debt to fixed or fixed rate to floating rate

2. lock in an attractive interest rate in advance of a future debt issue
3. position fixed rate liabilities in anticipation of a decline in interest rates
4. arbitrage debt price differentials in the capital markets.

Financial institutions, pension managers and insurers use swaps to balance asset and liability
positions without leveraging up the balance sheet and to lock-in higher investment returns for
a given risk level.

Did u know? What are the different types of swaps?
The two major types are:
1. Interest rate swaps (also known as coupon swaps)
2. Currency swaps

Self Assessment

Fill in the blanks:

1. A swap is a method for reducing ……………. risks.
2. A swap is a private agreement between two parties in which both parties are ……………to
exchange some specified cash flows at periodic intervals for a fixed period of time.

3. The date on which both the parties in a swap deal enter into the contract is known as
…………. .
4. Reset date is that date on which the ………….. rate is determined.

5. A swap is nothing but a combination of …………... .

9.2 Interest Rate Swaps

A standard fixed-to-floating interest rate swap, known in the market jargon as a Plain Vanilla
Coupon Swap (exchange borrowings) is an agreement between two parties in which each
contracts to make payments to the other on particular dates in the future till a specified termination
date. One party, known as the fixed rate payer, makes fixed payments all of which are determined
at the outset. The other party known as the floating rate payer will make payments the size of
which depends upon the future evolution of a specified interest rate index (6-month LIBOR).

An interest rate swap is an agreement between two parties to exchange U.S dollar interest
payments for a specific maturity on an agreed upon notional amount. The term notional refers
to the theoretical principal underlying the swap. Thus, the notional principal is simply a reference

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