Derivatives and Swaps: A Comprehensive Overview
GOOD
MORNING
Presentation on Swap
Presented by : Sujita Thapa
Concept of Derivatives
•
A
derivative
is a contract between two or more
parties whose value is based on an agreed-
upon underlying
financial asset
, or security.
•
Common underlying instruments include:
bonds, commodities, currencies,
interest rates
,
market indexes, and stocks.
Types of Derivatives
Concept of Swap
•
A swap is a
derivative
contract through which two
parties exchange financial instruments.
•
These instruments can be almost anything, but most
swaps involve
cash flows
based on a
national
principal amount
that both parties agree to.
•
The parties that agree to swap is called counterparties.
•
Swap is useful to hedge against interest rate risk and
currency risk.
Cont..
•
The swap agreement defines the dates when
the cash flows are to be paid and the way they
are
accrued
and calculated.
•
The cash flows are calculated over a notional
principal amount. Contrary to a future, a
forward or an option, the notional amount is
usually not exchanged between counterparties.
•
Parties enter into Swap to change the nature of
cash flow.
Features of Swap
•
Non-standardized contracts that are traded
over the
counter
(OTC),
•
Allow to deal with much longer horizons
than
exchange-traded
instruments,
•
Subject to credit risk.
•
Swaps are contracts that exchange
assets
,
liabilities
,
currencies, securities, equity participations and
commodities.
Swap Market
•
Swap market is market in which transaction on
swap is carried out.
•
Most swaps are traded over-the-counter
(OTC).
Types of Swaps
•
Interest rate swap
•
Currency swap
•
Equity swap
•
Commodity swap
Currency Swap
•
Currency swap is a contract between two
parties to exchange series of cash flows in
different currencies.
•
The principle amount are usually exchanged at
the beginning and at the end of the life of
swap.
•
Therefore there are three sets of cash flows:
the exchange of principle at initiation and
settlement and exchange of interest payments.
Interest rate swaps
•
Swap is the agreement between the two
parties that exchange sequences of cash
flows for a set period of time
Why swaps?
•
Convert financial exposure
•
Comparative advantage
•
Speculate on interest rates , currencies , etc.
•
There are different types of swaps: Interest
rate swaps, currency swaps, credit default
swaps, asset swaps, trigger swaps, commodity
swaps, total return swaps
•
Interest rate swap is a contractual agreement
between two parties to exchange interest
payments
•
Each participant in the swap is referred to as a
party, or together, as counterparties.
•
Financial institutions use interest rate swaps
to manage credit risk, hedge potential losses,
and earn income through speculation.
•
Interest rate swaps usually involve the exchange of a fixed
interest rate for a floating rate, or vice versa, to reduce or
increase exposure to fluctuations in interest rates or to
obtain a marginally lower interest rate
•
Swaps can be customized in many different ways
•
There are potential benefits and risks for both parties in an
interest rate swap. If interest rates rise, the payer benefits,
because their fixed rate is unchanged, and the receiver now
owes them the difference between the fixed rate and the
floating rate. If interest rates drop, the receiver wins,
because their floating rate is now lower than the fixed rate,
and they will be receiving the difference from the payer
How it works?
The most common type of interest rate swap is one
in which Party A agrees to make payments to Party
B based on a fixed interest rate, and Party B agrees
to make payments to Party A based on a floating
interest rate. The floating rate is tied to a reference
rate
(in almost all cases, the London Interbank
Offered Rate, or LIBOR).
For example, assume that
Charlie
owns a
$1,000,000
that
pays him LIBOR + 1% every month. As LIBOR goes up and
down, the payment Charlie receives changes.
Now assume that
Sandy
owns a
$1,000,000
investment that
pays her 1.5% every month. The payment she receives never
changes.
Charlie decides that that he would rather lock in a constant
payment and Sandy decides that she'd rather take a chance
on receiving higher payments.
So Charlie and Sandy agree to enter into an interest
rate swap contract.
Under the terms of their contract, Charlie agrees to pay
Sandy LIBOR + 1% per month on a $1,000,000 principal
amount (called the "notional principal" or "notional
amount").
Sandy agrees to pay Charlie 1.5% per month on the
$1,000,000 notional amount.
For instance: LIBOR = 0.25%
Charlie receives a monthly payment of
$12,500
from his investment
($1,000,000 x (0.25% + 1%)).
Sandy receives a monthly payment of $15,000
from her investment ($1,000,000 x 1.5%).
Now, under the terms of the swap agreement,
Charlie owes Sandy $12,500 ($1,000,000 x
LIBOR+1%) , and she owes him $15,000
($1,000,000 x 1.5%). The two transactions
partially offset each other and Sandy owes Charlie
the difference: $2,500.
Types of interest rate swaps
Plain vanilla swap
(fixed to floating or vice-versa)
Basis Swap
(floating to floating)
Interest rates swaps provides a way for
business to hedge against their exposure to
changes in interest rate swap
Thank you
Explore the concepts of derivatives and swaps, including their types, features, and the swap market. Delve into the details of how derivatives are used as contracts based on underlying financial assets, while swaps involve the exchange of financial instruments between parties. Learn about different types of swaps like interest rate swaps, currency swaps, and more.
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Presentation Transcript
GOOD MORNING
Presentation on Swap Presented by : Sujita Thapa
Concept of Derivatives Aderivative is a contract between two or more parties whose value is based on an agreed- upon underlying financial asset, or security. Common underlying instruments include: bonds, commodities, currencies, interest rates, market indexes, and stocks.
Concept of Swap A swap is a derivative contract through which two parties exchange financial instruments. These instruments can be almost anything, but most swaps involve cash flows based on a national principal amount that both parties agree to. The parties that agree to swap is called counterparties. Swap is useful to hedge against interest rate risk and currency risk.
Cont.. The swap agreement defines the dates when the cash flows are to be paid and the way they are accrued and calculated. The cash flows are calculated over a notional principal amount. Contrary to a future, a forward or an option, the notional amount is usually not exchanged between counterparties. Parties enter into Swap to change the nature of cash flow.
Features of Swap Non-standardized contracts that are traded over the counter (OTC), Allow to deal with much longer horizons than exchange-traded instruments, Subject to credit risk. Swaps are contracts that exchange assets, liabilities, currencies, securities, equity participations and commodities.
Swap Market Swap market is market in which transaction on swap is carried out. Most swaps are traded over-the-counter (OTC).
Types of Swaps Interest rate swap Currency swap Equity swap Commodity swap
Currency Swap Currency swap is a contract between two parties to exchange series of cash flows in different currencies. The principle amount are usually exchanged at the beginning and at the end of the life of swap. Therefore there are three sets of cash flows: the exchange of principle at initiation and settlement and exchange of interest payments.
Interest rate swaps Swap is the agreement between the two parties that exchange sequences of cash flows for a set period of time Why swaps? Convert financial exposure Comparative advantage Speculate on interest rates , currencies , etc.
There are different types of swaps: Interest rate swaps, currency swaps, credit default swaps, asset swaps, trigger swaps, commodity swaps, total return swaps Interest rate swap is a contractual agreement between two parties to exchange interest payments Each participant in the swap is referred to as a party, or together, as counterparties. Financial institutions use interest rate swaps to manage credit risk, hedge potential losses, and earn income through speculation.
Interest rate swaps usually involve the exchange of a fixed interest rate for a floating rate, or vice versa, to reduce or increase exposure to fluctuations in interest rates or to obtain a marginally lower interest rate Swaps can be customized in many different ways There are potential benefits and risks for both parties in an interest rate swap. If interest rates rise, the payer benefits, because their fixed rate is unchanged, and the receiver now owes them the difference between the fixed rate and the floating rate. If interest rates drop, the receiver wins, because their floating rate is now lower than the fixed rate, and they will be receiving the difference from the payer
How it works? The most common type of interest rate swap is one in which Party A agrees to make payments to Party B based on a fixed interest rate, and Party B agrees to make payments to Party A based on a floating interest rate. The floating rate is tied to a reference rate (in almost all cases, the London Interbank Offered Rate, or LIBOR).
For example, assume that Charlie owns a $1,000,000 that pays him LIBOR + 1% every month. As LIBOR goes up and down, the payment Charlie receives changes. Now assume that Sandy owns a $1,000,000 investment that pays her 1.5% every month. The payment she receives never changes. Charlie decides that that he would rather lock in a constant payment and Sandy decides that she'd rather take a chance on receiving higher payments. So Charlie and Sandy agree to enter into an interest rate swap contract. Under the terms of their contract, Charlie agrees to pay Sandy LIBOR + 1% per month on a $1,000,000 principal amount (called the "notional principal" or "notional amount"). Sandy agrees to pay Charlie 1.5% per month on the $1,000,000 notional amount.
For instance: LIBOR = 0.25% Charlie receives a monthly payment of $12,500 from his investment ($1,000,000 x (0.25% + 1%)). Sandy receives a monthly payment of $15,000 from her investment ($1,000,000 x 1.5%). Now, under the terms of the swap agreement, Charlie owes Sandy $12,500 ($1,000,000 x LIBOR+1%) , and she owes him $15,000 ($1,000,000 x 1.5%). The two transactions partially offset each other and Sandy owes Charlie the difference: $2,500.
Types of interest rate swaps Plain vanilla swap (fixed to floating or vice-versa) Basis Swap (floating to floating) Interest rates swaps provides a way for business to hedge against their exposure to changes in interest rate swap
