Swap Contracts: Structure and Elements

A swap contract allows counterparties to literally "swap" or trade one cash flow stream for another. That's pretty convenient in a number of cases, especially when you want to eliminate risk.

Who would want to hedge risk by being the "paying floating" counterparty in a swap?

Not really. If they paid floating, they would receive fixed payments both in the swap and elsewhere. The goal of hedging or eliminating risk is matching up opposite exposures.

Each swap is based on a notional amount, and the net payments are calculated based on that notional value. For example, suppose that a swap is agreed to with a USD 10 million notional. The "pay floating, receive fixed" party suddenly sees rates rise to 10%. What do you think this party will have to pay over the next year?

No, the notional amount of the swap is never paid. The payments are based on notional, but these are a certain percentage of that notional.

Not quite. Consider the "netting of payments" that's always part of a swap in a single currency.

Absolutely. The USD 10 million is never exchanged, but only the payments based on that notional value. Then there is some netting to be done. Maybe the swap was set up as "you pay MRR, and you'll get 3% fixed." Then if MRR rises to 10%, the pay floating would owe the difference of 7% of notional, or USD 700,000. Most are set up with quarterly payments, so this might trigger a payment of USD 175,000 or so.

Usually $$S_t$$ is the floating swap payment to be made, and $$FS$$ is the fixed payment. What would it mean if, in the first quarter of the swap, $$S_1 < FS$$?

Sure. Some person or institution may have floating interest payments coming in for the next few years, and are concerned about what will happen to rates. Being the "pay floating, receive fixed" side of a swap passes that risk to someone else, and likely someone who has the opposite risk exposure.

Not quite. That's a good idea, but it sounds more like speculation rather than hedging an existing risk.

No, that's only if these cash flows were equal.

Exactly. With the higher fixed payment, the "pay fixed" party pays, and the "pay floating" party gets a positive cash flow.

Not quite. The floating payment is smaller than the fixed payment, so the "pay floating" party wouldn't pay anything in net.

Why should this inequality not be expected for all periods?

Right! There's no way that you would agree to be a "pay fixed" counterparty in a swap if you expected it to always be larger than the floating payment. The expectation has to be that these will be even in order to make a swap agreement. The __swap rate__ is chosen so that this is the case; it's the rate that allows all expected payments in present value to sum to zero.

They usually do, but it's not a rule, especially over some fixed time frame.

No, that rule doesn't exist. Every swap will kind of produce a winning side and a losing side, since things don't always go as expected.

So a swap rate that's chosen to make everything balance in expectation... what does that make you think of?

Sure! All of these, in fact. Synthetic creation is good because yes, a swap is a series of cash flows that can be created from other existing instruments with the same cash flows and timing. It can be thought of as a series of bonds, or a portfolio of futures contracts, or even a portfolio of options. The arbitrage approach is exactly the idea here, and it goes right along with the law of one price. Since these other instruments exist with observable market values, the swap rate can be determined by looking at synthetic creation of a swap. So you might say that you can swap a swap for a synthetic swap! What fun.

To summarize: [[summary]]

The most common type of a swap is even called "plain vanilla" since it's so popular. It involves swapping a fixed payment for a floating payment, based on some floating interest rate.

USD 10 million

10% of USD 10 million

Less than 10% of USD 10 million

Someone who is receiving fixed payments elsewhere

Someone who is receiving floating payments elsewhere

Someone expecting interest rates to fall in the near future

There's no payment to be made

The "pay fixed" party must pay

The "pay floating" party must pay

There wouldn't be two willing parties

Interest rates have to vary in both directions

Swaps mandate that both parties receive the same payments in total

The law of one price

Arbitrage approach

Synthetic creation

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