6 - Swaps

Abstract

Swaps are off-balance sheet instruments involving combinations of two or more basic building blocks. The main types of swap are interest rate swaps, asset swaps, basis swaps, fixed-rate currency swaps and currency coupon swaps. Swaps are now one of the most useful instruments in the debt capital markets and are used by several institutions including banks, mortgage banks, and building societies. Interest rate swaps are the most important type of swap in terms of volume of transactions. They are used to manage and hedge interest rate risk and exposure, while market makers will also take positions in swaps that reflect their view on the direction of interest rates. The chapter discusses swap spreads and illustrates the swap yield curve. The swap spread is a function of the same factors that influence the spread over government bonds for other instruments. For shorter duration swaps there are yield curves that can be used in comparison, such as the market curve or a curve derived from futures prices. For longer-dates swaps the spread is determined mainly by the credit spreads that prevail in the corporate bond market. The chapter states the characteristics of interest rate swaps, or plain vanilla swaps, non-vanilla swaps, and currency swaps and provides an overview of interest rate swap applications.