Subject 6. Pricing and Valuation of Swap Contracts

Swaps are derivative securities in the form of agreements between two counterparties to exchange cash flows over a period of time, depending on the values of specified market variables.

Example

Party A agrees to pay a fixed rate of interest on $10 million each year for 3 years to Party B. In return, Party B agrees to pay a floating rate of interest on $10 million each year for 3 years to Party A.

A swap involves a series of payments over its tenor, and can be considered a series of forward contracts. In contrast, forwards, futures and options only involve a single payment or two payments (i.e., when the option is purchased and when it is exercised).

In general, neither party pays any money to the other at the initiation of a swap. A swap has zero value at the start.

A swap can be viewed as combining a series of forward contracts into a single transaction. However, there are some small differences. For example, swaps are a series of equal fixed payments, whereas the component contracts of a series of forward contracts would almost always be priced at different fixed rates. In this context we often refer to a swap as a series of off-market forward contracts, reflecting the fact that the implicit forward contracts that make up the swap are all priced at the swap fixed rate and not at the rate at which they would normally be priced in the market.

User Contributed Comments 0

You need to log in first to add your comment.