Page 127 - DMGT513_DERIVATIVES_AND_RISK_MANAGEMENT

Derivatives & Risk Management

Notes 9.2.1 Types of Interest Rate Swaps

Two main types of Interest Rate Swaps are: Coupon swap and Basis swaps.
1. Coupon swap: In a Coupon swap, one party pays a fixed rate calculate at the time of trade
as a spread to a particular Treasury bond, and the other side pays a floating rate that resets
periodically throughout the life of the deal against a designated index.
2. Basis swap: In a Basis swap, two parties exchange floating interest payments based on
different reference rates. Using this relative straightforward mechanism, interest rate
swaps transform debt issues, assets, liabilities, or any cash flow from type to type and-
with some variation in the transaction structure-from currency to currency.

Example: X promises to pay Y and Y promises to pay X, 3 months LIBOR to 3 months
T-Bills.
The most important reference rate in swap and other financial transactions is the London
Inter-Bank Offered Rate (LIBOR). LIBOR is the average interest rate offered by a specific group
of multinational banks in London for U.S dollar deposits of a stated maturity and is used as a
based index for setting rates of many floating rate financial instruments, especially in the
Eurocurrency and the Eurobond markets.

9.2.2 Other Types of Interest Rate Swaps

1. Forward Swaps: This is also known as deferred swaps, in which the commencement date
is delayed to a future date. This is mostly useful for those investors who do not need funds
immediately but would like to benefit from the existing rate of interest.
2. Callable Swap: A swap is said to be callable when it gives its holder (the fixed rate payer)
the right to terminate the swap at any time before its maturity. This is exercised when the
interest rates fall and then the fixed rate payer terminates the swap since the funds will be
available in the market a lower rate.
3. Puttable Swap: A Puttable swap provides the seller of the swap (the floating rate payer) to
cease the swap at any time before it maturity. If the interest rate rises, the floating rate
payer will terminate the swap.
4. Deferred Rate Swap: This allows the fixed rate payer to enter into a swap contract at any
time up to a specified future date. This is particularly attractive to those investors who
need funds immediately but do not consider the current rates of interest.
5. Rate capped Swaps: An interest rate swap incorporating the cap feature is called a rate
caped swap. For example, if a floating rate payer anticipates a rise in interest rate then he
can purchase a cap at a fee payable upfront to the fixed rate payer so that the floating rate
payable cannot exceed the capped rate.
6. Zero Coupon Swap: This is a variation of the plain vanilla swap in which the fixed rate
payer makes a single fixed payer at the maturity of the swap. The interest is calculated on
a discount basis, while the floating rate payer made periodic payments.
7. Extendable Swap: The extendable swap is constructed on the same principle as the double-
up swap, except that instead of doubling the swap, the provider has the right to extend the
swap, at the end of the agreed period, for a further predetermined period.
8. Forward Swap: A swap agreement created through the synthesis of two swaps differing
in duration for the purpose of fulfilling the specific time-frame needs of an investor. Also
referred to as a "forward start swap," "delayed start swap," and a "deferred start swap."

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