Complex Swaps Page


  

Vanilla swaps

Key facts
Swaps are the archetypal over-the-counter derivative instruments.
Although they are highly liquid, traded instruments, they remain privately negotiated contracts between counterparties - though these contracts now take the form of standardized master agreements.
They involve the exchange of fixed and/or floating payment streams based on interest rate, currency, equity, bond, commodity and real-estate indices.
They enable counterparties to exploit different markets' perceptions of their credit to raise cheaper capital, to access new markets by creating synthetic instruments and to manage currency and interest rate risks.
The main uses are:

  • To modify existing or future cash flows from an asset or liability for risk management purposes.
  • To alter an existing cash flow so that it matches a changed set of circumstances.
  • To decrease borrowing costs or increase investment yields.
  • To access markets synthetically that would otherwise be closed or uneconomical.
  • To modify cash flows for tax and accounting purposes.

  • Swaps are now used by every kind of user of the financial markets - banks, insurance companies, non-financial corporations and institutional investors.
    Standard swaps characterised by the following features:
  • The term of the swap is a whole number, commonly one, two, three, five, seven and 10 years.
  • The fixed and floating coupon payments take place at regular intervals, for example every six or 12 months.
  • The notional principal of the swap remains constant for the term of the swap.
  • The fixed rate remains constant for the term of the swap.
  • The floating rate is set at the beginning of each interest period and paid in arrears at the end of the interest period.
  • The basic swap structures are the commonest.
    However, because swaps are privately negotiated contracts the terms and conditions of any swap can be altered to suit the exact circumstances of the user.
    This flexibility has led to the creation of a family of swaps still regarded as vanilla - that is they do not have other derivative instruments combined with them and in particular which do not contain any option-like characteristics - whose basic form is the same as the standard interest rate and currency swaps but whose notional principal, coupon payments, period, fixing or final settlement terms are non-standard.
    There are also examples of swaps that do not conform to the standard structures in the following respects:
    1. Payment frequency mismatches when the floating-rate payment frequency differs from the term of the floating-rate index - example a swap in which a counterparty receives three-month Libor reset quarterly but paid semi-annually.
    2. Day-count mismatches where the fixed or floating payments of a swap are based on a convention that differs from the market convention of the currency involved.
    3. Irregular coupons such as short or long fixed or floating interest periods at the beginning or end of the swap or zero coupons.
    4. Non-standard tenors such as 18 months.
    5. Variable notional principal.
    6. Forward or deferred starts vii Off-market pricing where the fixed-rate payable is above or below the market rate resulting in additional payments by one counterparty.
    7. Floating margins - that is structures incorporating indices such as six-month Libor plus or minus a margin. While the market convention is based on flat Libor-based payments, a margin causes a discrepancy if the payment frequency and day count conventions for fixed and floating payments differ.
    8. Alterations to the standard rate set in advance, payment in arrears structure.
    9. Standarde swaps but on different asset classes.

    Accreting [principal] swap
    A currency or interest rate swap whose notional principal increases over its maturity. Created to fix the interest costs of projects funded by a series of predictable future drawdowns on a loan facility. Also known as a [staged] drawdown swap, escalating [principal] swap, step up swap.

    Amortizing swap
    A swap whose notional principal decreases over the life of the instrument.
    In the simple versions the notional principal decreases according to a fixed schedule that is determined at the outset of the swap.
    This allows, for example, users to convert amortizing fixed-interest securities (i.e. bonds with sinking funds or early redemption provisions) into floating-rate securities.
    This type of amortizing swap can be seen as a series of separate swaps with the total swap price reflecting a weighted average of the individual swap rates or it can be seen as one swap of a particular duration and priced as a swap with this maturity.
    An interest rate swap that converts the cash flows from an amortizing debt instrument or index into a fixed-swap payment is also known as a level payment swap.
    In the more complex versions the amortization is linked to an underlying index, for example interest rates, a foreign exchange rate or mortgage prepayment rates, but the timing of the amortization is not known at the outset of the swap and depends on the path of the underlying index. These are known as index amortizing swaps. In these instruments the fixed-rate receiver has sold a series of complex swaptions to the payer. They are described in the chapter on complex swaps and see also under index amortizing note in the chapter on derivative-linked securities.)

    Annuity swap
    A cross-currency swap in which there is no exchange of principal, just interest payments. Also known as coupon-only swaps they are usually used to swap dual currency bonds into just one of their currencies. So a bond whose principal is denominated in dollars with coupons paid in yen can be swapped into dollars by an issuer willing to pay dollars and receive yen to cover the interest on the bond. Since the bond principal is already in dollars there is no need to include it in the swap agreement. The term annuity swap is also used of a type of amortizing swap in which an irregular payment stream is exchanged for a regular payment stream of the same present value. It is usually found in currency swap markets where it is used to exchange a set of even cashflows in one currency for an equivalent (in value and evenness) cash flow in a second currency. A series of long term forward foreign exchange contracts would create an uneven series of payments. So if a company wishes to swap an annuity stream of USD10 million over five years into yen, it can either treat the dollar annuity as an amortizing loan and execute an amortizing USD/JPY currency swap or it can use a currency annuity swap whose swap rate depends on how much of the early JPY cash flows have to be borrowed from (or lent to depending on interest rate differentials) the later cash flows.

    Back-to-back swap
    A swap agreement with the same terms and opposite counterparties to an existing swap such that, if entered into, it will cancel out the obligations of the original swap. These swaps are more complex than simply cancelling an existing agreement and so will only be used if there are specific tax or accounting benefits. Also known as a reverse swap.

    Basis swap
    A floating-floating interest-rate or cross-currency swap under which two counterparties exchange interest flows on two different floating rate reference indices.
    They arose from banks' needs to hedge the spread exposure between different short-rates, for example lending at prime and funding in Libor.
    So some of the commonest basis swaps are, CP for Libor, T-bill for Libor, six-month Libor for six-month Libor reset monthly or three-month USD Libor for three-month JPY Libor and hence the alternative name for a basis swap, money market swap.
    They are also used to hedge the interest rate risk in a currency swap.
    Basis swaps can be created from two interest rate swaps in which the two fixed legs cancel out between counterparties and the two floating legs are as required.
    They are also common in commodity markets where they are used to hedge fluctuations on spreads between different products.

    CMT/CMS swap
    A yield curve swap in which one leg is linked to CMT rates.
    One counterparty pays the CMT or CMS rate at one part of the curve, say the two-year CMS or CMT rate, and receives it at a different part of the curve, say 10 years. Interest rate swaps can be indexed to many indices. So, a COFI swap is a swap one of whose legs is referenced to the 11th District Cost of Funds Index, a US interest rate index important to savings and loan institutions. Sometimes used as a reference rate in swaps and bonds, particularly when short rates are expected to fall, because movements in COFI tend to lag short-term rates. Other indices commonly used are Prime, Fed Funds, Libor and the many domestic rates found in local fixed-income markets. Collateralized swap
    A swap agreement in which one or both counterparties puts up collateral to guarantee its ability to meet its obligations under the agreement. Commodity swap
    In its vanilla form an agreement identical to a fixed-for-floating interest rate swap except that the payment streams are based on the price of a commodity such as crude oil or its distillates, non-ferrous metals and bullion.
    Example
    An oil producer wishing to lock in the price of his production of 600,000 barrels a year can pay a floating rate equal to the pre-agreed price index times 50,000 barrels a month and receive a pre-agreed fixed amount per barrel on the same notional 50,000 bbl/month. The fixed price is set upfront by reference to the prevailing swap or forward market. An oil consumer would enter such a swap as a fixed payer. Typically no oil changes hands. The producer continues to sell 50,000 barrels a month to the market and channels that floating payment stream into the swap in exchange for the fixed rate. Physical delivery can be accommodated.

    Concertina swap
    An interest-rate swap whose notional principal varies according to the present value of an existing fixed-rate paying swap and which is used to increase near-term protection from high floating rates. While the notional principal is normally adjusted within a concertina, rate and tenor can also adjusted. Also known as an accordion swap and a net present value (NPV) swap.

    [Cross]-currency swap
    The spot sale of one currency for another combined with a simultaneous forward agreement to repurchase the agreed currency amounts at a pre-set date and an agreement by the counterparty in the lower interest rate currency to make periodic payments to the counterparty in the higher interest rate currency in that currency. This payment is approximately equal to the interest rate differential between the two currencies. Also known as a cross-currency [interest] rate swap. As with interest rate swaps they can be fixed-fixed, fixed-floating or floating-floating.
    Example
    The issuer of a five-year $100 million 6.0% fixed-rate Eurobond is funding a project which will generate a five-year floating-rate yen return. It wants to hedge the mismatch between the floating-rate yen asset and the fixed-rate dollar liability (i.e. against yen depreciation and falling yen rate) to lock in the spread on the project. Currency swap rates are at 6.20% against yen Libor. The issuer pays yen Libor and receives 6.20% in USD.
    The notional amount is $100 million on the dollar side and 12.5 billion on the yen side. As well as the periodic payments under the swap there are two principal exchanges: at the initiation of the swap the issuer pays $100 million (the bond proceeds) to the swap counterparty and receives 12.5 billion. On maturity this exchange reverses: the issuer pays 12.5 billion to the counterparty and receives $100 million with which it redeems the bond. The combination of the swap and bond synthesizes a five-year floating yen liability and the issuer retains any spread earned.

    Cross-currency basis swap
    A basis swap in which the reference indices are in different currencies. Principal amounts can be exchanged or the basis swap can be structured as a coupon swap. They are functionally just a rolling series of short-dated forward foreign exchange transactions and are used to hedge a wide variety of cross-currency products such as cross-currency interest rate swaps and cross-currency equity swaps. They are also used by borrowers to transfer liquidity in one currency into their desired funding currency.

    Deferred [coupon] swap
    A swap in which some or all of the payments are deferred for a pre-set period after they have been calculated and come due. These are tax or accounting driven and payments tend to be deferred across fiscal year ends and other key balance sheet dates.

    Equity swap
    A type of total return swap (see chapter 16) in which both capital appreciation and any dividend or coupon income from one index or individual equity are exchanged for a floating-rate payment usually based on a Libor plus or minus a spread. The instrument swaps all the economic risks associated with the underlying without actually transferring the underlying, often with tax advantage. They are useful for gaining unfunded (leveraged) exposure to equity markets and can also be used for quick and relatively cheap asset allocation alterations. So, for example, an investor long US dollar floating rate assets wishes to exchange that exposure for exposure to the S&P500 equity index. He enters a swap paying US dollar Libor and receiving the total returns where positive from the S&P500 plus or minus a margin. If the index returns are negative he pays the difference between zero and the index performance to the counterparty in addition to the floating rate payment. Typically both the index-return payments and the floating-rate payments occur monthly or quarterly. The payments are calculated on a notional principal amount that is not exchanged. Payment streams can be denominated in the same or different currencies. Equity swaps can be structured to have variable or fixed notional principal; they can be single- or cross-currency; and the cross-currency versions can be currency hedged (quantized) or unhedged. An equity swap is essentially a long-term equity future and so the cost of carry is crucial in pricing (and determines the margin paid out with or deducted from the index returns. The payer of the index return is short the index. To hedge this position he borrows floating rate, using the Libor payment stream he receives from the swap counterparty to service the loan, and buys the index. To fulfil his obligation to pay the total returns from the index, he pays out the dividends and capital appreciation he receives from his position in the index.

    Fixed [-for-] fixed swap
    Currency swaps in which both counterparties pay a fixed rate.

    Fixed-rate payer
    The swap counterparty that undertakes to pay fixed in a swap. Also said to be the buyer of or long the swap. So the floating-rate payer is the swap counterparty that undertakes to pay floating in a swap. Also said to be the seller of or short the swap. Forward/deferred [start] swap A swap that begins at an agreed date in the future. Forward or deferred start swaps are used to lock-in funding costs commencing at a specified time in the future when the borrower believes that funding costs will rise significantly in the intervening period. They can also be used to extend existing swaps or liabilities to suit a changing asset or liability profile. A forward start swap whose start date coincides with the termination date of an existing swap and which will automatically extend the original transaction is also known as an extension swap. Forward start swaps can be used to re-finance capital markets transactions and monetize embedded call options in bonds in much the same way as swaptions.

    Interest rate swap
    An agreement between two counterparties to exchange interest rate payments on a notional principal sum which is not exchanged.
    The commonest structure is the fixed-for-floating swap in which one counterparty agrees to pay a fixed rate over the term of the swap in exchange for a floating-rate payment payable by the other counterparty.
    The vanilla fixed-for-floating interest rate swap is also sometimes called a coupon swap since it can be viewed as swapping the coupons from two bonds with the same principal.
    A swap, viewed from the pay fixed side, can be considered either as a portfolio of FRAs all with the same strike or as a portfolio which is short a coupon bond and long an FRN or, alternatively, as the combination of a cap and floor with the same strike.
    Swaps are actively traded and are generally quoted on a yield basis, that yield being the yield to maturity that equates the present value of the fixed side to that of the floating side.
    Quotes generally refer to the fixed leg or coupon.
    A five-year dollar swap quoted at 60 bid 65 offer means that a counterparty wishing to pay fixed and receive Libor flat would have to pay the market-maker a fixed rate which is 65 basis points over the yield to maturity of the five-year US treasury at the time the swap is initiated.
    If he wanted to pay Libor and receive fixed, the counterparty would receive a fixed-rate of 60 bp over.
    So, the swap bid is the price at which a counterparty will buy a stream of Libor-linked cash-flows and the offer is the price at which they would sell a stream of Libor-linked cashflows.
    Swap pricing depends on the term structure of interest rates, the swap spread, transaction costs and credit risk.
    There is generally no upfront premium for a swap, as at the outset of the swap both parties are theoretically indifferent as to whether they are in fixed or floating: the net present value of the two payment streams is zero.
    Since the price of an interest rate swap is the level at which the market is indifferent between paying a fixed rate or interest and a stream of Libor, it depends entirely on implied forward Libor rates.
    This means that a hedger must, before he decides to fix, determine whether he believes rates will rise as far as the implied forward curve implies.
    In steep yield curve environments, where the implied forward curve is even steeper, fixing incurs negative carry.
    Example
    A typical hedging application would be a corporate treasurer with US$1 billion of US dollar outstanding floating rate debt who believed that dollar interest rates were set to rise.
    To increase his level of fixed-rate debt and protect himself against rate rises, this treasurer could enter into a fixed-floating semi-annual swap on US$500 million notional principal under which he would pay a fixed rate (the swap rate) and receive a floating rate linked to an index such as Libor.
    Every six months, a net interest payment is made between swap counterparties.
    If the prevailing level of dollar Libor is higher than the fixed rate (the swap rate) then the swap counterparty pays the treasurer the difference.
    If the swap rate is higher than Libor, the treasurer pays the counterparty the difference.
    This netting fixes the treasurer's interest rate.
    The swap can be reversed at any time.
    The unwind valuation is the difference between the present values of two sets of cashflows: that of the future cash flows payable/receivable under the swap and that of the cash flows for a matching but offsetting swap.
    The market is effectively buying the right to continue the swap on its original terms.
    If these are better than the current terms then the swap has positive value.
    On a five-year swap that had run for one year, the comparison would be with a current four year swap.
    If the implied forward curve had shifted up sufficiently for the current four-year swap rate to exceed the original five-year swap rate, then the swap would have positive value as the market would be able to buy the (now higher) stream of Libors for the old (lower) price.

    Leveraged swap
    A swap in which the fixed-rate receiver receives an above-market fixed rate and pays a multiple of the floating rate index.
    Example
    An investor who believes that the future spot rate will be lower than the rate implied by the forward curve can simply receive fixed and pay floating under a swap.
    To increase returns, he can transact the swap on twice the notional principal of his liabilities.
    If he has a limit on notional principal, he can substitute a leveraged swap: he pays twice (or more) the floating rate but on the same notional principal as the original swap.
    At the extreme he can receive a very high fixed rate and pay Libor-squared.
    Since Libor-squared rises faster the higher Libor is, this is extremely speculative.

    Libor-in-advance swap
    An interest rate swap in which the Libor rate is reset at the beginning of the previous period except for the first period where Libor is set at the beginning of the corresponding period as in a conventional swap.
    This effectively shifts the floating Libor periods back by one period except for the first.
    The Libor-in-advance swap allows the fixed-rate payer to pay a lower fixed rate in exchange for receiving Libor in advance in the same type of interest rate environment if the yield curve is positive.

    Libor-in-arrears swap
    In a conventional swap, floating interest payments are reset in advance, at the beginning of each (usually semi-annual) period and paid in arrears.
    So the six-month Libor rate payable in six months' time is determined by the Libor rate in effect at contract origination and paid at the end of the six-month period.
    At the 12-month settlement, the coupon payment is determined by the six-month Libor rate prevailing at month six and so on.
    In a Libor-in-arrears swap, interest payments are both set and paid in arrears.
    That is, the first Libor fixing is after six months, just two days before the payment date, and is determined by the six-month Libor rate in effect at month six (not at contract origination) and subsequent rates are set at the end of each period.
    So, with a standard swap both parties know the amount of the floating-rate payment six months in advance.
    With the Libor-in-arrears swap, neither party knows what the payment will be until it is due.
    This effectively extends the floating-rate payer's exposure to Libor by one additional interest period and means that the forward rates that are used to determine the fixed-rate payment in the swap are one period further out than on a standard swap.
    If the yield curve is steeply positive, this means that the fixed-rate for the Libor-in-arrears swap will be higher than for the standard swap because the forward rates are higher.
    Another way of looking at it is that the market is implying that short-term rates will rise.
    Therefore the market expects that setting Libor in arrears will result in a higher Libor being set and therefore a higher payment than if Libor is set normally.
    Therefore the market will pay an incentive to any counterparty that wishes to pay Libor in arrears.
    So, if the market is expecting Libor to be on average higher at the end of each six-month period by 50 bp, then in a floating-floating Libor-in-arrears swap a counterparty could receive Libor and pay Libor-in-arrears less 50 bp.
    The swap would be advantageous if Libor falls over the period or rises by less than 50 bp.
    This shows how the swap is priced: the market expects Libor to rise 50bp over each floating period and so is willing to receive Libor-set-in-arrears less 35 bp.
    The price adjustment is therefore the present value of the average expected increase in Libor over the period, calculated from implied forward Libors for that period.
    Also known as an arrears [rate] reset swap, delayed Libor reset swap.
    Libor-in-arrears swaps are a way of taking a view that future spot rates will be lower than those implied by the forward curve, though the buyer's view on absolute rates may not be much different from that expressed by a conventional swap.
    If interest rates do not rise as sharply as the yield curve suggests, the Libor payments will be less than those on a conventional swap.
    Most commonly they are used by fixed-rate receivers (for example, treasurers swapping fixed-rate bond issues into floating) who benefit from the steepness of the yield curve by paying Libor-in-arrears in exchange for a higher fixed rate.
    Floating-floating versions are sometimes used by investors who would receive Libor and pay Libor-in-arrears if they believed rates will not rise as fast as the implied forward curve suggests.
    There are a number of more recent variants of the structure.
    In a less aggressive version of the Libor-in-arrears swap, counterparties can choose to receive a fixed-rate and pay floating with the other counterparty having the option to pay Libor-in-arrears (and receive a higher fixed rate).
    The fixed-rates payable will be lower than that in the full Libor-in-arrears swap to take into account the cost of this option.
    Alternatively, if the counterparty wants to take a more aggressive view on the forward curve than in the standard Libor-in-arrears swap, he can choose to receive an even higher fixed rate than in the Libor-in-arrears swap in exchange for agreeing to pay the greater of six-month Libor and six-month Libor in arrears.
    This floating rate liability could be capped at a catastrophe level.

    Mark-to-market swap
    A standard swap (of any kind) except that, periodically, it is marked to market.
    The counterparty on whose side the mark-to-market value is positive pays that value to the counterparty showing a mark-to-market loss.
    This greatly reduces the credit exposure the counterparties have to each other through the swap.
    Options on this varying exposure are also available see mark-to-market cap.
    Credit derivatives hedge this credit risk in a different way by guaranteeing to make good any mark-to-market loss realized in the event of default.
    See swap guarantee.

    Mismatched payment swap
    A swap in which payment streams are not exchanged on the same date.
    For example, the floating amounts are payable semi-annually but the fixed amounts are payable quarterly.

    Multi-rate reset swap
    A swap in which the reset and payment periods are unusually frequent.
    For example, an interest rate swap in which the floating-rate payer pays one-month Libor on a monthly basis.

    Off-market swap
    A swap in which the fixed-rate payments are below or above the market rate.
    Where it is below the swap is known as a discount swap.
    At maturity the discount is repaid with one payment.
    The structure is useful in financing projects which will not generate income to pay under the swap until they are completed.
    When the fixed rate is above the market rate the structure is known as a high-coupon swap.
    The floating-rate payer may compensate the fixed-rate payer either by higher periodic payments or by payment of an upfront fee.

    Overnight indexed swap (OIS)
    A fixed-to-floating interest rate swap whose floating rate is based on a weighted average rate for overnight transactions.
    The two counterparties exchange at maturity the difference between interest accrued at the fixed rate and the compounded daily overnight rate.
    These swaps are used to hedge cash deposits.

    Real-estate swap
    A swap involving the exchange of the returns from a pre-agreed property index, such as the US Russell NCREIF Property Index, a benchmark index which takes into account the yield on 1,800 properties throughout the US, for a financial index such as Libor.
    Such swaps are used by institutional investors who wish to re-allocate assets away from property at times of low yields, but who do not want to take the capital loss of selling the property in a bear market.

    Roller-coaster swap
    A generic name applied to swaps whose notional principal is different in different payment periods.
    Such swaps' notional principal generally increases and decreases periodically to accommodate cashflows that differ predictably on a seasonal basis or to accommodate debt obligations scheduled to rise and fall.
    Hence the alternative name, the seasonal swap.

    Rolling reset swap
    A swap where one counterparty pays the lower of the arranged swap rate or the prevailing market rate on the roll date for the same tenor.

    Roll-lock swap
    A swap used to hedge roll risk.
    This is the risk that long-term hedgers face when using short-term contracts.
    As each expiration approaches, hedgers sell futures contracts they own and re-enter the position in a more distant month.
    The cost differences can be expensive and can also create tracking error.
    Under a roll-lock swap the roll-lock payer pays the average of the cost of the roll (defined as the difference between the near and next futures contract)
    measured at pre-agreed times before expiration.
    The roll-lock receiver pays a Libor-based rate set at a pre-agreed time after the expiration of the near contract.
    Also known as a roll-over lock.

    step up [coupon] swap
    An interest rate swap whose fixed-rate payments rise over time according to a schedule determined at the outset of the swap.
    Also known as an escalating rate swap.

    [Swap] spreadlock
    A contract that locks in a predetermined swap spread for a deferred start swap.
    So a future fixed-rate payer {receiver} is guaranteed a maximum {minimum} spread over a specified benchmark index (usually a government bond rate) in a forward swap.
    The swap provider agrees to provide a borrower/hedger with a swap deferred over a defined period (usually less than six months) at a preset spread over a reference (usually Treasury) rate comparable to the maturity of the swap into which the hedger is obliged to enter.
    This guarantees the issuer of a bond, for example, a swap at a known credit margin over the relevant reference rate while enabling that borrower to take advantage of any absolute movement in rates.
    A payer {receiver} spreadlock allows the holder to enter into a swap paying {receiving} the reference rate plus the agreed spread.
    Also known as a deferred rate setting swap.

    Tax-exempt swap
    An interest rate swap with one or both payment streams based on tax-exempt US municipal bond yields or a tax-exempt index such as the JJ Kenney.
    Also known as municipal swaps.

    Variable maturity swap
    A swap whose maturity is uncertain but whose range is predefined.
    For example a swap whose maturity is between two and three years contingent on Libor reset dates.

    Yield curve [arbitrage] swap
    A swap in which the counterparty moves up or down the yield curve twice in the same swap, yield curve swaps are a type of basis swap in which a shorter-term floating-rate index is swapped for a longer-term floating-rate index. In the commodity markets such swaps are known as contango swaps and backwardation swaps depending on whether the forward curve is positively or negatively sloped. In both, counterparties exchange a payment stream based on the nearby futures contract for one based on a more distant futures contract. A yield curve swap in which the returns from more than one market are swapped for the returns from one market is known as a combination yield curve swap. For example, a counterparty might pay the two-year CMS Euro rate and receive 50% of the two-year CMS Euro rate plus 50% of the two-year CMS yen rate. A yield curve swap can be viewed as a series of forward swaps each of which starts on the yield curve swap's reset dates. (This is also one way to hedge them but in practice it is expensive and hedging is done on a portfolio basis).
    Example 1
    An investor believes that the US dollar yield curve will steepen. He enters into a US$50 million notional principal yield curve swap under which he pays three-month Libor and receives the 10-year Constant Maturity Swap (CMS) rate less 200 basis points. If the spread between short and long rates widens, then the investor can reverse the swap or close it out to take profits. The swap is priced by comparing the forward curves for the two indices, valuing the implied cash flows separately and then calculating a swap spread such that the net present value of the two implied cashflows is zero.
    Example 2
    A commodity consumer could use a backwardation swap to fix the spread differential between spot and forward prices to offset the costs they would incur if the spread relationship reversed, for example if absolute prices fell. Under this type of swap the consumer might pay the average daily price of the nearby futures contract and receives the six-month or 12-month contract plus a spread. If the curve flattens, the profit on the swap offsets the higher cost of hedging new forward purchases.
    In a contango swap the user locks in a favourable contango, or positive spread, between forward and nearby prices.
    So an oil producer might pay the monthly average of the daily difference between the nearby and 12-month WTI futures contract on a pre-agreed notional principal amount of oil and receive a fixed spread of 30 cents per barrel.
    Another way of looking at the structure is that the producer pays a floating amount equal to the average of the 12-month futures contract and receives a floating payment equal to the average nearby contract plus the 30 cent spread.
    This enables the commodity producer to lock in the positive spread between forward and nearby prices and also to hedge against anticipated backwardation.

    Zero-coupon swap
    An interest rate swap in which the floating payment streams are usually conventional but the fixed-rate payments are made through a single lump sum payment calculated on the basis of the present value, discounted to that payment date, of the stream of fixed payments that would have been payable over the term of a conventional swap.
    The present value is usually adjusted to take account of the greater credit risk involved in this kind of mismatched structure.
    The lump sum payment can be made at any time during the life of the swap.
    The term zero coupon swap is usually applied to a swap in which the fixed-rate payments are deferred to maturity.
    If the lump sum payment is made at the outset of the transaction the swap is known as a reverse zero-coupon swap

    pre-paid swap.
    In both cases the mismatched structure makes the swap is functionally equivalent to a loan and entails similar credit risks, though it is usually off-balance sheet for accounting purposes.
    Zero-coupon swaps can also be used to hedge the payment stream on a zero coupon bond.


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