Characteristics of Swap Contracts

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A __swap__ can be thought of as a contract that binds a series of forward commitments. In a forward contract, the two parties transact once at the maturity of the contract. In a swap, the two parties transact multiple times. As an example, consider the dilemma of the jeweler who needs to purchase gold in the future for a ring business. The jeweler needs to purchase 1,000 ounces of gold every three months for the next year, purchasing a total of 4,000 ounces of gold. What do you think is the best option from the perspective of the jeweler?

No, this option is complicated and generates needless transaction costs.

No, this option is not attractive as it leaves the jeweler exposed to gold price risk.

What do you think is the potential downside to this option?

Correct. As a swap is a bundle of forward contracts which are traded over the counter (OTC), swaps are similarly traded OTC so the jeweler is exposed to counterparty risk. However, the jeweler benefits by having his or her trades not being made public as no exchange is involved and the contract can be fully customized to suit the jeweler's needs.

No, swaps are a bundle of forward commitments that trade over the counter. Therefore, the trades are not private and provide a lot of privacy for the investors.

No, like forward commitments, swaps trade over the counter and so they can be fully customized to suit the buyer.

The most common type of swap agreement is the __fixed-for-floating interest rate swap__. In this type of contract one party swaps variable rate interest payments for fixed rate interest payments. One is a __floating-rate payer__ and the other is a __fixed-rate payer__. As a borrower, what risk might cause you to enter into such an agreement and trade a floating rate of interest for a fixed?

Correct. If you expected interest rates were going to increase, you would want to enter an interest rate swap to change a variable rate loan into a fixed rate loan to lock in your borrowing costs.

Incorrect. If you expected interest rates were going to decrease, you would want to switch from a fixed to a variable rate loan so that your borrowing costs would go down when rates decrease.

Just like forward contracts, swap contracts specify the underlying asset, the volume or value to be transacted at each settlement date, the forward prices for each settlement, and the time and location of the settlement. Relating these characteristics to the example, the jeweler's swap contract would specify the following: 1. Amount to be transacted at each settlement is 1,000 ounces. 2. Settlement will be quarterly, with a total for settlements reflecting full maturity of the contract in one year. 3. The forward price for each settlement. 4. The timing and location of each settlement. The forward price at each settlement is not necessarily the same and the settlement is determined in the same manner as a forward contract.

Correct, well done! This option minimizes transaction costs and locks in the price of gold for the next year with settlements coinciding with her purchasing needs.

The swap is based on some __notional__ value. Maybe a bank trades 2% on USD 10 million of notional in exchange for LIBOR or something like that. The notional isn't exchanged. It's just a matter of saying "okay, this quarter LIBOR is 2.08%, so the pay floating party has to give the pay fixed counterparty a quarter of 0.08% of the 10 million." Then a payment for that USD 2,000 is made.

Purchase multiple futures contracts, each with a different maturity

Purchase gold now and every three months for the next nine months

Purchase a swap contract with a quarterly settlement frequency with a maturity of one year

Counterparty risk

Lack of privacy regarding trading activity

Limited customizability

The risk that interest rates may increase

The risk that interest rates may decrease

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