LOS a: Describe the characteristics of swap contracts and explain how swaps are terminated

The notional principal is generally not swapped, as it is usually the same for both parties in the swap deal.

The most common type of interest rate swap is called a plain vanilla interest rate swap. It involves trading fixed interest rate payments for floating-rate payments. Notional principal is generally not swapped in single currency swaps.

Swaps typically do not require a payment from either party at initiation. The exception is currency swaps.

Parties to swaps contracts are usually large institutions, rarely individual speculators or hedgers.

As the English pound increases in value, it takes more U.S. dollars to pay off the English liability, which increases the interest cost of borrowing funds denominated in English pounds.

The futures market, because of the use of a standardized contract, is more liquid; and, because the exchange guarantees the contract, futures contracts have less credit risk. However, swaps contracts, because they are over-the-counter (private) contracts, allow the firm to maintain privacy.

The futures market uses a standardized contract, which increases the liquidity of the contract. Also, futures exchanges assume the credit risk. However, as the time horizon increases, the liquidity of futures contracts decreases substantially. Therefore, swaps are considered a better method of hedging over long time horizons.

During the 1980s, some parties entered the swap market in an effort to exploit perceived market inefficiencies. Today, the uses of the swaps market are not motivated by perceived informational inefficiencies.

Historically, there were two basic motivations for swaps: to exploit perceived market inefficiencies and to attempt to obtain cheaper financing. Both of these motivations are based on the concept that the financial markets are inefficient. This fact, unfortunately, is no longer true. Today, the swap markets are mature and offer few arbitrage opportunities. Swap markets are now viewed as being more operationally efficient and a more flexible means of packaging and transforming cash flows than any other method. The reasons given now for using the swap markets are to: reduce transactions costs, avoid costly regulations, and maintain privacy.

Since the notional principal swapped is the same (and in the same currency) for both counterparties, there is no need to actually exchange cash. The counterparties are the pay-fixed and receive-fixed sides. A swap facilitator helps to bring the counterparties together and may be either an agent or a broker. The tenor of the swap is the time frame covered by the deal, or the time to maturity of the swap.

Swap contracts are largely unregulated.

The plain vanilla interest rate swap involves trading fixed interest rate payments for floating rate payments. Swaps are a zero sum game, what one party gains the other party loses. In interest rate swaps, only the net interest rate payments actually take place because the notional principal swapped is the same for both counterparties and in the same currency units, there is no need to actually exchange the cash.

The notional principal is the amount swapped. Note that the notional principal does not actually change hands with plain vanilla interest rate swaps, but is used to calculate the interest payment streams to be exchanged. Notional principal does exchange hands in a foreign currency swap.

Interest rates and bond prices are inversely related. Therefore, as interest rates increase, the value of the T-bonds decreases. The bank may wish to engage in a swap contract wherein the bank pays fixed and receives variable. In this case, as interest rates rise, the bank receives higher variable payments for making the same fixed payment in the swap. The cash flows received in the swap offset the reduction in the bond portfolio’s value.

Exploiting market inefficiencies is no longer considered a motivation for entering into swap agreements. Historically, there were two basic motivations for swaps, to exploit market inefficiencies and to attempt to obtain cheaper financing. Both were based on the belief that financial markets were inefficient. Today, the swap markets have matured and there are few arbitrage opportunities. The swap markets are considered operationally efficient and flexible. Thus, the main reasons to enter into swap agreements today include: to reduce transaction costs, to avoid costly regulations, and to maintain privacy.

The parties agreeing to swap cash flows are called the counterparties.

As the Australian dollar decreases in value, the interest payments from the bond (and perhaps the bond’s face value if the bond is at maturity), translate into fewer U.S. dollars, which reduces the interest earned on the Australian bonds.

In interest rate swaps, there is no need to actually exchange the notional amount, since the notional principal swapped is the same for both counterparties and in the same currency units. Net interest is paid by the one who owes it at settlement dates.

Explanations for other responses:

The reasons given now for using the swap markets are to: reduce transactions costs, avoid costly regulations, and maintain privacy. Historically, there were two basic motivations for swaps: to exploit perceived market inefficiencies and to attempt to obtain cheaper financing. Both of these motivations are based on the concept that the financial markets are inefficient. This fact, unfortunately, is no longer true.  Today, the swap markets are mature and offer few arbitrage opportunities. Swap markets are now viewed as being more operationally efficient and a more flexible means of packaging and transforming cash flows than any other method. Currency swaps often occur because of comparative advantage. For example, parties may want to reduce borrowing costs. One firm may have better access to a country’s domestic capital markets than another firm. The U.S. firm (D) may have access to the U.S. capital markets but not the German markets, while the German firm (M) may have access to the German markets but not the U.S. markets. If each firm borrows locally and then exchanges the funds, they will both gain.

In a currency swap, interest payments are made without netting. Full interest payments are exchanged at each settlement date. Currency swap counterparties actually exchange notional principal because the motivation of the parties is to receive foreign currency.

The notional principal is the dollar amount specified in the swap agreement. The counterparties use the notional principal to determine the amount of the interest payments. They generally do not exchange the notional principal.

Because it involves two different currencies, this would be a currency swap.

Unlike interest rate swaps, notional principal is swapped at both the initiation and the termination of the swap. Full interest payments are exchanged at each settlement date. Exploiting market inefficiencies was once a motivation for currency swaps, but it is not today (because the market is efficient). Today motivations range from reducing transactions costs to maintaining privacy to avoiding regulation.

The notional amount is used to calculate both the fixed and the floating rate payment streams. Both of the other choices are true.