Derivatives. Pirie Wendy L.

early 1980s. Thus, it may be somewhat surprising to learn that the swap is the most widely used derivative, a likely result of its simplicity and embracement by the corporate world. The most common swap is the fixed-for-floating interest rate swap. In fact, this type of swap is so common that it is often called a “plain vanilla swap” or just a “vanilla swap,” owing to the notion that vanilla ice cream is considered plain (albeit tasty).

Let us examine a scenario in which the vanilla interest rate swap is frequently used. Suppose a corporation borrows from a bank at a floating rate. It would prefer a fixed rate, which would enable it to better anticipate its cash flow needs in making its interest payments.10 The corporation can effectively convert its floating-rate loan to a fixed-rate loan by adding a swap, as shown in Exhibit 2.

EXHIBIT 2 Using an Interest Rate Swap to Convert a Floating-Rate Loan to a Fixed-Rate Loan

      The interest payments on the loan are tied to a specific floating rate. For a dollar-based loan, that rate has typically been US dollar Libor.11 The payments would be based on the rate from the Libor market on a specified reset date times the loan balance times a factor reflecting the number of days in the current interest calculation period. The actual payment is made at a later date. Thus, for a loan balance of, say, $10 million with monthly payments, the rate might be based on Libor on the first business day of the month, with interest payable on the first business day of the next month, which is the next reset date, and calculated as $10 million times the rate times 30/360. The 30/360 convention, an implicit assumption of 30 days in a month, is common but only one of many interest calculation conventions used in the financial world. Often, “30” is replaced by the exact number of days since the last interest payment. The use of a 360-day year is a common assumption in the financial world, which originated in the pre-calculator days when an interest rate could be multiplied by a number like 30/360, 60/360, 90/360, etc., more easily than if 365 were used.

      Whatever the terms of the loan are, the terms of the swap are typically set to match those of the loan. Thus, a Libor-based loan with monthly payments based on the 30/360 convention would be matched with a swap with monthly payments based on Libor and the 30/360 convention and the same reset and payment dates. Although the loan has an actual balance (the amount owed by borrower to creditor), the swap does not have such a balance owed by one party to the other. Thus, it has no principal, but it does have a balance of sorts, called the notional principal, which ordinarily matches the loan balance. A loan with only one principal payment, the final one, will be matched with a swap with a fixed notional principal. An amortizing loan, which has a declining principal balance, will be matched with a swap with a pre-specified declining notional principal that matches the loan balance.

      As with futures and forwards, no money changes hands at the start; thus, the value of a swap when initiated must be zero. The fixed rate on the swap is determined by a process that forces the value to zero, a procedure that will be covered later in the curriculum. As market conditions change, the value of a swap will deviate from zero, being positive to one party and negative to the other.

      As with forward contracts, swaps are subject to default, but because the notional amount of a swap is not typically exchanged, the credit risk of a swap is much less than that of a loan.12 The only money passing from one party to the other is the net difference between the fixed and floating interest payments. In fact, the parties do not even pay each other. Only one party pays the other, as determined by the net of the greater amount owed minus the lesser amount. This does not mean that swaps are not subject to a potentially large amount of credit risk. At a given point in time, one party could default, effectively owing the value of all remaining payments, which could substantially exceed the value that the non-defaulting party owes to the defaulting party. Thus, there is indeed credit risk in a swap. This risk must be managed by careful analysis before the transaction and by the potential use of such risk-mitigating measures as collateral.

      There are also interest rate swaps in which one party pays on the basis of one interest rate and the other party pays on the basis of a different interest rate. For example, one party might make payments at Libor, whereas the other might make payments on the basis of the US Treasury bill rate. The difference between Libor and the T-bill rate, often called the TED spread (T-bills versus Eurodollar), is a measure of the credit risk premium of London banks, which have historically borrowed short term at Libor, versus that of the US government, which borrows short term at the T-bill rate. This transaction is called a basis swap. There are also swaps in which the floating rate is set as an average rate over the period, in accordance with the convention for many loans. Some swaps, called overnight indexed swaps, are tied to a Fed funds–type rate, reflecting the rate at which banks borrow overnight. As we will cover later, there are many other different types of swaps that are used for a variety of purposes. The plain vanilla swap is merely the simplest and most widely used.

      Because swaps, forwards, and futures are forward commitments, they can all accomplish the same thing. One could create a series of forwards or futures expiring at a set of dates that would serve the same purpose as a swap. Although swaps are better suited for risks that involve multiple payments, at its most fundamental level, a swap is more or less just a series of forwards and, acknowledging the slight differences discussed above, more or less just a series of futures.

      EXAMPLE 3 Forward Contracts, Futures Contracts, and Swaps

      1. Which of the following characterizes forward contracts and swaps but not futures?

      A. They are customized.

      B. They are subject to daily price limits.

      C. Their payoffs are received on a daily basis.

      2. Which of the following distinguishes forwards from swaps?

      A. Forwards are OTC instruments, whereas swaps are exchange traded.

      B. Forwards are regulated as futures, whereas swaps are regulated as securities.

      C. Swaps have multiple payments, whereas forwards have only a single payment.

      3. Which of the following occurs in the daily settlement of futures contracts?

      A. Initial margin deposits are refunded to the two parties.

      B. Gains and losses are reported to other market participants.

      C. Losses are charged to one party and gains credited to the other.

      Solution to 1: A is correct. Forwards and swaps are OTC contracts and, therefore, are customized. Futures are exchange traded and, therefore, are standardized. Some futures contracts are subject to daily price limits and their payoffs are received daily, but these characteristics are not true for forwards and swaps.

      Solution to 2: C is correct. Forwards and swaps are OTC instruments and both are regulated as such. Neither is regulated as a futures contract or a security. A swap is a series of multiple payments at scheduled dates, whereas a forward has only one payment, made at its expiration date.

      Solution to 3: C is correct. Losses and gains are collected and distributed to the respective parties. There is no specific reporting of these gains and losses to anyone else. Initial margin deposits are not refunded and, in fact, additional deposits may be required.

      This material completes our introduction to forward commitments. All forward commitments are firm contracts. The parties are required to fulfill the obligations they agreed to. The benefit of this rigidity is that neither party pays anything to the other when the contract is initiated. If one party needs some flexibility, however, it can get it by agreeing to pay the other party some money when the contract is initiated. When the contract expires, the party who paid at the start has some flexibility in deciding whether to buy the underlying asset at the fixed price. Thus, that party did not actually agree to do anything. It had a choice. This is the nature of

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Banks prefer to make floating-rate loans because their own funding is typically short term and at floating rates. Thus, their borrowing rates reset frequently, giving them a strong incentive to pass that risk on to their customers through floating-rate loans.

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It is possible that the notional principal will be exchanged in a currency swap, whereby each party makes a series of payments to the other in different currencies. Whether the notional principal is exchanged depends on the purpose of the swap. This point will be covered later in the curriculum. At this time, you should see that it would be fruitless to exchange notional principals in an interest rate swap because that would mean each party would give the other the same amount of money when the transaction is initiated and re-exchange the same amount of money when the contract terminates.