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Structuring interest rate derivatives I: Swaps

This is the first one of a sequence of blogs where I will try to analyze and explain real derivatives used by firms in order to reduce their cost of funding. The purpose of this blog is to explain concepts that are not clarified by theoretical books.

This is so because derivatives structuring is a combination of art and science.

You need creativity to come up with brand new concepts, then solid technical skills together with computer modeling skills are a must, and finally commercial skills in order to convince the world to use your products.

Exotics are the products beyond the easy/simple ones or «plain vanilla». We called them plain vanilla making an analogy with vanilla ice-cream: as simple as you can get it. Let´s bear in mind that today´s plain vanilla products used to be exotics 5/10 years ago because innovation drives this business at the speed of light.

Lets take a look at swaps first:

A swap is an OTC derivative which involves the exchange of cash payment streams between two counterparties on an agreed amount for a fixed time period. Each payment stream is known as a leg of the swap.

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Swaps are designed to manage exposure to risk, such as index values or interest rates and for speculation purposes. Swaps are available across the asset classes.

Interest rate swaps are the most common type of swap.

A interest rate swap is an exchange of payment streams (usually in cash) between two counterparties on an agreed amount of debt (the notional) for a fixed time period.

The payments streams exchanged can be either fixed or floating as follows:

Fixed and floating
Floating and fixed
Floating and floating
Fixed and fixed

The floating rate is set according to the chosen reference rate. Usually the rate is set at the start of each payment period and paid at the end of that payment period (in advance). However, the floating rate can also be set at the end of the period (in arrears).

What interest rate swaps are available?
Available interest rate swaps include the following but there are many others:

Callable swap
Cancelable swap
CMS swap
CMS spread swap
Cross-currency swap
Forward rate agreement (FRA)
Inverse floater
Knock in swap
Quanto swap
Range accrual swap
Vanilla swap
Zero coupon swap

Note Many (but not all) of these swaps can be an:
Amortizing swap.
Accreting swap

In this sequence of blogs I will explain each of the concepts to make your life easier.

See you next!

Antonio Rivela
IE Business School Finance Professor
Managing Director netvalue consultores