An interest rate swap is a forward contract in which one stream of future interest payments is exchanged for another based on a specified principal amount. 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 than would have been possible without the swap.
Summary
In the management of interest rate volatility, and associated asset and liability management decisions, tools such as swaps and interest rate options provide a great degree of coverage flexibility and customisation. Interests rate swaps are customise to protect it user from changes interest rates. On the other hand, caps and floors are asymmetric instruments in that they provide protection in capping liability costs and they protect the rates of return on investments.
Swaps can be used as asset and liability management tools. We have also touched on the features of two interest rate options, namely, caps and floors and how they can be used to create synthetic swaps.
Self-Assessment / Activity
1. A _________________ of a swap agreement will receive floating rate interest payments.
A. floating-rate payer
B. receive fixed party
C. fixed-rate payer
D. swap counterparty
2. Which of the following statement about swaps are INACCURATE?
I swaps are highly flexible contract.
II swaps trade on both over-the-counter markets as well as organised exchanges.
III swaps carry default risk even though there is a clearing house that takes the other side of every transaction.
IV swaps can be interpreted as either a package of futures contracts or a package of cash market instruments.
A. I only
B. II and III
C. II and IV
D. I, II and III
Question 3 and 4 are based on the following information:
A bank entered into a swap agreement as a fixed rate payer with a notional principal amount of RM20 million. The swap agreement is for two years with semiannual settlement dates. the fixed rate is 8% while the the floating rate is 1% plus KLIBOR.
3. Assume KLOBOR fell to 6% at the first settlement date. What is the net cash flow to the bank at this time?
A. -RM100,000
B. RM98,630
C. RM100,000
D. -RM98,630
4. Assume KLIBOR rose to 7.5% on the second settlement date. What is the net cash flow to the counterparty (floating rate payer) of the swap agreement at the second settlement date?
A. RM0
B. RM50,000
C. RM45,000
D. -RM50,000
Additional Questions:
1. What is SWAP?
A. is refers to a type of financial contract whose value is dependent on an underlying asset, group of assets, or benchmark.
B. is refers to a financial instrument that is based on the value of underlying securities such as stocks, indexes, and exchange traded funds (ETFs).
C. are a type of derivative contract agreement to buy or sell a specific commodity asset or security at a set future date for a set price.
D. is based on an exchange of two series of fixed cash flows.
Note:
SWAP is a derivative contract through which two parties exchange the cash flows or liabilities from two different financial instruments. Swaps are agreements between two or more parties to exchange sequences of cash flows over a certain period of time. At least one sequence is uncertain when the swap agreement is initiated. The parties who agree to swap cash flows are called counterparties. For example, counterparties A agrees to pay a fixed rate interest payment to counterparty B in exchange for variable interest rate payments from counterparty B. In general, there are two basic types of swaps – (a) interest rate swaps and (b) currency swaps. A swap can also involve the exchange of one type of floating rate for another, which is called a basis swap