Question

Explain the general principle behind the various swap rate formulas. Why does this process give a fair swap rate? HTML Editora

Answer 1

A swap rate is the rate of the fixed leg of a swap as determined by its particular market and the parties involved. In an interest rate swap, it is the fixed interest rate exchanged for a benchmark rate such as Libor, plus or minus a spread. It is also the exchange rate associated with the fixed portion of a currency swap.

How Does the Swap Rate Work?

Swap rates are applied to different types of swaps. An interest rate swap refers to the exchange of a floating interest rate for a fixed interest rate. A currency swap refers to the exchange of interest payments in one currency for those in another currency. In both types of transactions, the fixed element is referred to as the swap rate.

What Does an Interest Rate Swap Tell You?

In an interest rate swap, one party will be the payer and the other will be the recipient of the fixed rate. The cash flow of the fixed rate leg of the swap is set when the trade is undertaken. The cash flow for the floating rate leg is set periodically on the rate reset dates, which are determined by the reset period of the floating rate leg.

The most common index for the floating rate leg is the three-month Libor. This can either be paid quarterly or compounded and paid semi-annually. The rate above or below the chosen Libor reflects the yield curve and credit spread to be charged.

Interest rate payments between fixed and floating rate legs are netted at the end of each payment period and only the difference is exchanged.

What Does a Currency Swap Tell You?

There are three types of interest rate exchanges for a currency swap:

1. The fixed rate of one currency for the fixed rate of the second currency.
2. The fixed rate of one currency for the floating rate of the second currency.
3. The floating rate of one currency for the floating rate of the second currency.

The swap can include or exclude a full exchange of the principal amount of the currency at both the beginning and the end of the swap. The interest rate payments are not netted because they are calculated and paid in different currencies. Regardless of whether or not the principal is exchanged, a swap rate for the conversion of the principal must be set.

If there is no exchange of principal, then the swap rate is simply used for the calculation of the two notional principal currency amounts on which the interest rate payments are based. If there is an exchange, where the swap rate is set can have a financial impact since the exchange rate can change between the start of the agreement and its conclusion.

The most common is the vanilla swap. It's when a one party swaps an adjustable-rate payment stream with the other party's fixed-rate payments.

There are a few terms used:

• The receiver or seller swaps the adjustable-rate payments. The payer swaps the fixed-rate payments.
• The notional principle is the value of the bond. It must be the same size for both parties. They only exchange interest payments, not the bond itself.
• The tenor is the length of the swap. Most tenors are from one to several years. The contract can be shortened at any time if interest rates go haywire.2
• Market makers or dealers are the large banks that put swaps together. They act as either the buyer or seller themselves. Counterparties only have to worry about the creditworthiness of the bank and not that of the other counterparty. Instead of charging a fee, banks set up a bid and ask prices for each side of the deal. In the past, receivers and sellers either found each other or were brought together by banks. These banks charged a fee for administering the contract.3

The net present value of the two payment streams must be the same. That guarantees that each party pays the same over the length of the bond.

The NPV calculates today's value of all total payments. It's done by estimating the payment for each year in the future for the life of the bond. The future payments are discounted to account for inflation. The discount rate also adjusts for what the money would have returned if it were in a risk-free investment, such as Treasury bonds.

The NPV for the fixed-rate bond is easier to calculate because the payment is the same each year. The adjustable-rate bond payment stream is based on Libor, which can change.4 Based on what they know today, both parties have to agree then on what they think will probably happen with interest rates.

Advantages

The adjustable-rate payment is tied to the Libor, which is the interest rate banks charge each other for short-term loans. Libor is based on the fed funds rate.5 The receiver may have a bond with low interest rates that are barely above Libor. But it may prefer the predictability of fixed payments even if they are slightly higher. Fixed rates allow the receiver to forecast its earnings more accurately. This elimination of risk will often boost its stock price. The stable payment stream allows the business to have a smaller emergency cash reserve, which it can plow back.

Banks need to match their income streams with their liabilities. Banks make a lot of fixed-rate mortgages. Since these long-term loans aren’t paid back for years, the banks must take out short-term loans to pay for day-to-day expenses. These loans have floating rates. For this reason, the bank may swap its fixed-rate payments with a company's floating-rate payments. Since banks get the best interest rates, they may even find that the company's payments are higher than what the bank owes on its short-term debt. That's a win-win for the bank.

The payer may have a bond with higher interest payments and seek to lower payments that are closer to Libor. It expects rates to stay low so it is willing to take the additional risk that could arise in the future.

Similarly, the payer would pay more if it just took out a fixed-rate loan. In other words, the interest rate on the floating-rate loan plus the cost of the swap is still cheaper than the terms it could get on a fixed-rate loan.

Disadvantages

Hedge funds and other investors use interest rate swaps to speculate. They may increase risk in the markets because they use leverage accounts that only require a small down-payment.

They offset the risk of their contract by another derivative. That allows them to take on more risk because they don't worry about having enough money to pay off the derivative if the market goes against them.

If they win, they cash in. But if they lose, they can upset the overall market functioning by requiring a lot of trades at once.