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D. M. Chance An Introduction to Derivatives and Risk Management, 6th ed. Chapter 10: Swaps I once had to explain to my father that the bank didn’t really make its money taking deposits and lending out money to poor folk so they could buy houses. I explained that the bank actually traded for a living. Stan Jonas Derivatives Strategy, April, 1998, p. 19 Important Concepts in Chapter 12 The concept of a swap Different types of swaps, based on underlying currency, interest rate, or equity Pricing and valuation of swaps Strategies using swaps Definition of a swap Four types of swaps Currency Interest rate Equity Commodity (not covered in this book) Characteristics of swaps No cash up front Notional principal Settlement date, settlement period Credit risk Dealer market See Figure 12.1, p. 426 for growth in world-wide notional principal Interest Rate Swaps The Structure of a Typical Interest Rate Swap Example: On December 15 XYZ enters into $50 million NP swap with ABSwaps. Payments will be on 15th of March, June, September, December for one year, based on LIBOR. XYZ will pay 7.5% fixed and ABSwaps will pay LIBOR. Interest based on exact day count and 360 days (30 per month). In general the cash flow to the fixed payer will be Interest Rate Swaps (continued) The Structure of a Typical Interest Rate Swap (continued) The payments in this swap are Payments are netted. See Figure 12.2, p. 428 for payment pattern See Table 12.1, p. 429 for sample of payments after-the-fact. Interest Rate Swaps (continued) The Pricing and Valuation of Interest Rate Swaps How is the fixed rate determined? A digression on floating-rate securities. The price of a LIBOR zero coupon bond for maturity of ti days is Starting at the maturity date and working back, we see that the price is par on each coupon date. See Figure 12.3, p. 430. Interest Rate Swaps (continued) The Pricing and Valuation of Interest Rate Swaps (continued) By adding the notional principals at the end, we can separ