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Swaps Summary for Finance and IT Professionals

Manoj Kochhar



This is a short summary paper on the swaps market.


What Is A Swap ?

A swap is an agreement between two or more counterparties to exchange sets of cash flows over a period in the future. A swap has an opening leg (the initial exchange, also called the near-leg), a set of cashflows (not always), and finally a closing leg (the final exchange, also called the far-leg).


Common characteristics of swaps:

  1. There is an underlying notional principle (specified as an amount of a commodity in a commodity swap, specified as a stock portfolio in an equity swap)
  2. There is a fixed tenor
  3. One party pays fixed whilst the other pays floating or both parties pay floating.



What Instruments Make Up The Swaps Market ?


The main type of swap is the Interest Rate Swap (IRS). Equity swaps and commodity swaps also exist. The main type of IRS is a currency swap and it is discussed later.


Interest rate swaps are the most heavily traded swap product. 



Swaps Market


The swaps market is entirely OTC. There are swap brokers and swap broker dealers and specialist clearing houses such as the London Clearing House that clear inter-bank interest-rate swap trades. Most traders do not clear their swaps through a clearing house but hedge the risk on their own books.


Swaps are generally cash settled although physical delivery occurs for some commodity swaps.





In a short-term swap (or money market swaps) the closing leg can be up to two years ahead.


In a long/medium-term swap the closing leg can be from two years onwards (I've seen a 30-year swap traded).




Interest Rate Swap


An interest rate swap (IRS) is the exchange of two payment streams between two counterparties over an agreed period. The payments are calculated using different interest rates and are based on the same notional principle amount.  The purpose of an IRS is to allow counterparties to convert an exposure from one stream of payments into a second stream of payments.  Normally, an IRS is the exchange of a fixed payment for a floating payment with no principle being exchanged.


In essence an interest rate swap can be analysed as a portfolio of forward contracts with successive expiration dates. It can similarly, be considered as a strip of interest rate futures contracts.




Joxo agrees to pay Barclays 6% a year for five years on $10 million in return for Barclays paying Joxo a 6-month LIBOR on the same sum. The notional amount ($10 million) is not actually transferred. Cash flows are normally netted so that only the difference is paid by one of the counterparties.


IRS are used to get better borrowing rates. If one company wants to borrow fixed-rate funds and another company wants to borrow floating-rate funds it makes sense for them to swap. The former can raise funds by issuing a floating rate note whilst the latter can raise funds by issuing a fixed rate bond.



Swap prices are quoted in two ways:


  1. An outright rate e.g. 6.5-7.0% (bank will receive fixed at 7% versus LIBOR or pay fixed at 6.5% versus LIBOR)
  2. A spread over a reference rate such as the US treasury yield for the period of the swap



Many different types of IRS products exist. There are swap futures and forwards where the opening leg is set to some future date. Swap futures are traded on LIFFE. Swap options are fairly popular and are called swaptions.


A coupon swap is an interest rate swap in which one stream of payments is based on a fixed interest rate and the other stream on payments is based on a floating interest rate.


A basis swap is an interest rate swap in which both streams of payments are based on floating interest rates but each is calculated on a different basis.


An asset swap is where one of the one payment streams is being funded by an underlying asset (e.g. a bond), although the asset is never exchanged. They are commonly used to create fixed-rate cash flows from a floating-rate position or vice-versa.


An overnight index swap is a fixed/floating rate short-term swap where the floating rate is referenced to the daily overnight rate.


An EONIA swap is a fixed/floating rate swap where the floating rate is referenced to the EONIA.


A forward outright swap (aka IRS outright)  is when the near-leg is completed at the spot rate whilst the far-leg is completed at the forward rate.


An extendable swap is when counterparties agree to extend the term of a swap.


Other types of interest rate swap:

Amortizing swap

Accreting swap

Inflation swap

Index swap

Seasonal swap

Roller coaster swap

Off-market swap

Quanto swap

Yield Curve swap

Index swap

Variance swap

Credit derivative swaps (CDS, TRS etc.)



Currency Swap


A currency swap is the exchange of a fixed amount of one currency per annum for a fixed amount of another currency per annum followed by an exchange of principal on maturity of the swap. It is commonplace, but not essential, to exchange currency on the opening leg of the swap. All currency flows are paid at an exchange rate agreed in advance.


A cross-currency swap (as opposed to just a currency swap) involves the exchange of cashflows in different currencies with at least one of the cashflows being based on a floating rate of interest. Therefore, a cross-currency swap is either a cross-coupon swap or a cross-currency basis swap.


Currency swaps are used to hedge foreign currency exposures.  The most heavily traded currency swaps are: US dollars, Euro, Yen and Sterling .


Other types of currency swap:

Seasonal currency swap

Circus swap



Equity Swap


An equity swap is the exchange of two payment streams between two counterparties over an agreed period where the first party makes payments that are based on the returns on a stock or a stock index and the counterparty makes payments of either a fixed amount, a floating amount or payments based on the returns of a stock or a stock index.


The returns from an equity swap can be negative.




Commodity Swap


A commodity swap is the exchange of two payment streams between two counterparties

where the cashflows are dependant on an underlying commodity. The first party (e.g. an oil user) would pay a fixed amount and receive payments based on the market value of the commodity involved (i.e. a specified volume of the commodity over a specified period). Note that an oil producer would do the opposite i.e. make payments based on the market value of the commodity and receive fixed payments for the commodity.


  Commodity swaps are used to lock-in the price of a commodity.





A s waption (option on a swap) provides the right but not the obligation to enter into a price swap at a particular point in the future and at a set price. The buyer can be the fixed-rate receiver (call swaption) or the fixed-rate payer (put swaption). The agreed strike rate represents the fixed rate that will be swapped against the floating rate.



Lifecycle For Vanilla Swaps


1.Trade Date (aka fixing date). The terms of the swap are agreed i.e. maturity, swap rate, floating interest rate index, payment frequency, notional principle amount.


2. Start Date. Date on which the first floating rate is set. For spot swaps this is the trade date. For forward start swaps it is after the trade date.


3.Value Date. The interest payments start to accrue. This is either the trade date (for domestic currency) or T+2 for foreign currency.


4.Refixing Date. The floating rate index is adjusted to the current market rate for

the next interest period.


5.Effective Date. Interest is paid for the preceding period.  Effective dates are normally calculated from value dates and are normally the same day as the refixing date (for domestic currency) or two business days later (for foreign currencies).


6.Maturity Date. The last interest payments are made. Maturity is agreed at the start or calculated using the value date.


The tenor is the period in years from value date until maturity date.

The front stub period is the time from value date until the first payment.



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