Chapter 16

Swaps

Parts One and Two of this book have already devoted substantial attention to the valuation and risk of the fixed sides of interest rate swaps. This chapter, therefore, focuses more on the valuation and risk of the floating sides of swaps and on other assorted issues relating to swap markets. These latter topics include counterparty risk, recent legislative and regulatory efforts to “clear” swaps, basis swaps, and constant-maturity swaps (CMS).

SWAP CASH FLOWS

Through an interest rate swap two parties agree to exchange interest payments calculated at a fixed rate for interest payments calculated at a short-term rate that changes over time. For discussion, consider the following swap. On May 28, 2010, party A agrees to pay party B 1.235% on $100 million semiannually for two years while party B agrees to pay party A three-month LIBOR quarterly on that same amount over that same period. In the terminology of the swap market, 1.235% is the fixed rate and three-month LIBOR is the floating rate. Party A pays fixed and receives floating while party B receives fixed and pays floating. The $100 million is the notional amount of the swap, rather than face or principal amount, because it is used solely to calculate the interest payment: the notional amount is never itself exchanged. Table 16.1 gives the cash flows of this swap using illustrative levels of three-month LIBOR realized on future dates.