# Interest Rate Swaps and Other Derivatives

## Howard Corb

- English
- ePUB (mobile friendly)
- Available on iOS & Android

# Interest Rate Swaps and Other Derivatives

## Howard Corb

## About This Book

The first swap was executed over thirty years ago. Since then, the interest rate swaps and other derivative markets have grown and diversified in phenomenal directions. Derivatives are used today by a myriad of institutional investors for the purposes of risk management, expressing a view on the market, and pursuing market opportunities that are otherwise unavailable using more traditional financial instruments. In this volume, Howard Corb explores the concepts behind interest rate swaps and the many derivatives that evolved from them.

Corb's book uniquely marries academic rigor and real-world trading experience in a compelling, readable style. While it is filled with sophisticated formulas and analysis, the volume is geared toward a wide range of readers searching for an in-depth understanding of these markets. It serves as both a textbook for students and a must-have reference book for practitioners. Corb helps readers develop an intuitive feel for these products and their use in the market, providing a detailed introduction to more complicated trades and structures. Through examples of financial structuring, readers will come away with an understanding of how derivatives products are created and how they can be deconstructed and analyzed effectively.

## Frequently asked questions

## Information

^{1}Nowadays the swaps market is so liquid and vast that when an investor executes a swap, a dealer who takes the other side does not need to first line up yet another counterparty on the other side. These days if someone wants to do a swap, he approaches any one of a number of major swap dealers to do the trade.

^{2}And nearly as fast as one could execute a Treasury trade, one can now execute a swap.

^{3}

*notional*(or fictitious principal) on all trades has changed from year to year. Figure 1.1 shows just how rapid this growth has been. The outstanding notional of interest rate swaps, interest rate options, and currency swaps combined first crossed the $100 trillion threshold in the year 2003 and crossed $400 trillion by 2008. By comparison, the outstanding amount of U.S. Treasury securities in 2008 was on the order of magnitude of $5.7 trillion.

^{4}This is a bit of an apples and oranges comparison since the outstanding notional of derivatives relates more to trading volume (and does not account for the fact that some outstanding trades offset one another, meaning the net risk in the marketplace may be far less than suggested in Figure 1.1), and the outstanding amount of Treasuries is not indicative of trading volume. But hopefully this leaves the impression that the swaps market is pretty big.

*Source:*Bank for International Settlements.

*swap*is a contractual agreement between two counterparties that agree to exchange streams of payments over time. If both streams of payment are made in the same currency, then the trade is known as an

*interest rate swap*; if the streams are made in two different currencies, then the swap is referred to as a

*cross-currency swap*. We will spend virtually all of our time focusing on interest rate swaps, and we will further restrict our attention to swaps denominated in U.S. dollars (USD).

*coupon swap*or

*fixed-floating swap*or

*plain vanilla swap*refers to a swap in which one stream is a fixed rate of interest, and the other is a floating rate of interest. In a

*basis swap*, both streams are floating rates of interest.

^{5}Instead of saying â30/360,â people will sometimes say âbond,â and instead of saying âAct/360,â people will sometimes say âmoney.â

^{6}Oftentimes when people speak about swaps, they will use terms like this since they are quicker to say, and every second counts when the market is moving and it is desirable to execute a trade quickly. In fact, when referring to the payment frequency and day count convention in a standard swap, sometimes people will abbreviate this even further by saying something like âsemi bond versus threes.â Saying âthreesâ surely takes less time than saying â3-month LIBOR paid quarterly on an Act/360 basis.â And for counterparties that deal with each other frequently and are comfortable that these standard conventions always apply when they transact swaps with one another, they may not even bother to discuss standard payment and day count conventions before doing a swap.

^{7}

*notional*, or fictitious principal, upon which payments are made is $100mm.

^{8}Note that there will be a total of ten payments made by the client (the first of which is in six months) and 20 payments made by the dealer (the first of which is in three months) over the life of the swap. Final payments will occur five years after the

*effective date*, or start, of the swap. The actual payments made on the fixed and floating side in the swap are

*x*%, the final payment on the floating side of the swap is

^{9}Note that Figure 1.2 shows that the fixed rate in the swap, which is 1.647%, is also expressed as

*T*

_{5}+21, where

*T*

_{5}represents the yield of the

*on-the-run*5-year Treasury at the time the swap is executed.

^{10}Thus the

*swap rate*(also called the

*par swap rate*), the fixed rate set in the swap when it is first executed such that the trade has zero net present value to either side, is equal to the yield of the on-the-run 5-year Treasury plus some spread. In this case the spread is 21 basis points (bps).

^{11}The

*swap spread*for a swap of a given maturity is defined as the spread in bps that is added to the yield of the on-the-run Treasury of comparable maturity to obtain the swap rat...