Derivatives - Swaps

    Interest Rate and Currency Swaps (CFA Level II Suggested Reading)

    • A swap is a financial contract that involves the exchange of cash flows between two counter-parties
    • A plain vanilla swap is a multi-period financial contract in which two parties exchange certain cash flows
    • Features and conventions of a plain vanilla swap
    • The notional amount of a swap can be set to vary according to the need of the end-user, leading to amortising and accreting swaps
    • Understanding different variations of swap structures, such as the zero coupon swap, the single coupon swap and the process of bootstrapping
    • A cross currency swap is a financial contract that constitutes an agreement between two parties to exchange cash flows arising from a set of obligations denominated in different currencies
    • The most basic type of cross currency swap is a currency basis swap
    • This contract involves the exchange of two sets of cash flows, both of which are based on the LIBORs in the respective currencies
    • A cross currency interest rate swap is a contract in which one or both interest payments are based on a fixed rate

    Swaps Applications and Accounting

    • Understand why the swaps markets grew exponentially between the mid-1980s and the late-1990s
    • Why swaps are mainly used by corporate borrowers and institutional investors
    • Swaps markets follow different conventions in different currencies
    • The three types of interest rates relevant in swaps operations: swaps yields, zero coupon rates and forward rates
    • The general application of swaps in asset-liability management
    • How corporates and banks use swaps to hedge new bond issues
    • How investors use swaps to construct asset swaps
    • Swaps are treated as off-balance sheet contracts
    • Understand the differences between the mark-to-market method and the hedge accounting method
    • Know how swaps are defined under FAS 133 (in US GAAP) and its international counterpart IAS 39
    • The tax treatment of derivatives varies from one jurisdiction to another
    • The two most important factors for determining the tax treatment of these contracts are nature and timing
    • The 1992 ISDA master agreement has simplified swaps documentation

    Swaps Valuation and Risk Management

    • There are two methods of calculating interest: simple and compound interest
    • Importance of using the correct rate conventions, i.e. day count convention, periodicity or business day convention when calculating swaps coupons
    • Understand the terms time value of money, future value, present value and NPV
    • Valuation of interest rate swaps and currency swaps
    • Market participants often tweak the process to ensure that the mark-to-market value is a true reflection of the economic value of the contract by using: mid-market and unwind value
    • The first step in swaps risk management is to determine the market factors that affect the value of the given contracts
    • The second step is to quantify this sensitivity/exposure by using measures such as: PVBP, delta and Macaulay duration
    • The third step is to reduce the market risk to an acceptable level through a process of hedging
    • The final step is to monitor the market risk and maintain it within an acceptable range by adjusting the hedge
    • Swaps contracts provide a mechanism for end-users to transfer their exposures to market makers

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