Brief Introduction to Concept of Swaps and Swap Contracts
Financial Risk Manager (FRM®) Part I of the FRM Exam covers the fundamental tools and techniques used in risk management and the theories that underlie their use.
Welcome to the 30th session in your preparation for the FRM Part I exam. We are almost halfway through the Financial Markets module, and until now we have learned about futures, forwards and options. In this session, we will introduce a very interesting concept called swaps, wherein one can transfer the cash flow liabilities to another person and vice versa. For example, one can convert a fixed rate loan into a floating rate loan. This is done by entering into a swap agreement.
The agenda of our discussion will be learning about swap contracts. We will begin by introducing the concept of swaps. We will then learn about plain vanilla swaps using both bonds and forward rate agreements. We will then learn about currency options. The calculations might seem a bit tricky, but as you practice, it will become quite easy. Questions from this section (especially about currency swaps) are always asked in the exam, so you are advised to fully understand the concepts as well as the numerical questions. We will end the session with a brief discussion on the comparative advantage of swaps and the risk involved in swaps.
Let us now understand what swaps are. Imagine that one person is holding a semi-annual bond that pays a 4percent coupon on a principal of Dollar100,000. This person receives a fixed payment of Dollar2000 every six months as coupon payments, as shown in the slide. Consider another person holding a bond that pays floating interest based on a six-month LIBOR. Suppose that the interest rates for the next 3 periods are 4percent, 4.5percent and 4.8percent; then this person will receive Dollar2000, Dollar2250 and Dollar2400 every six months. Now, they mutually agree and enter into a contract so that the person receiving a fixed payment will pay this fixed payment to the person receiving floating payment, and in return, the other person will pay the floating payment to the first person. The net payment is shown in the chart. Therefore, the contract enables both parties to interchange their cash flow liabilities. We also find that the net payment is positive for one party and negative for other. As such, the present value of the net positive payment to one party becomes the value of the initial contract known as the value of the swap. The agreement is termed as a swap.