Just as the financial engineers at banks all over the world have developed
exotic options that have specifically tailored payoff profiles that differ
specifically from the payoff profile of plain vanilla options, these same
groups have come up with new products in the swap market. Whether the evolution
of these new financial products has been driven by the demand of the end-user
for tools that help them tailor their risk profiles more individually or it has
been guided by the incessant need for banks to create new markets, it is
important to have a general overview of these instruments and how they can be
used. This article will introduce some of the more common non-vanilla swaps.
Recall that there are often many names for the same product when it is issued
by different and competing financial institutions.
The Delayed Start Swap
Just as its name suggests, the delayed start swap is a regular plain vanilla
swap exchanging cash flows in one index against cash flows in another index
with the exception that the start date of the swap is not immediate.
Why would anyone want to use a delayed start swap? To match the swap's
cashflows with their existing cash flows.
Suppose that you are the CFO of a company that has outstanding corporate
bonds with semiannual coupon payments, payable June 30 and December 31 of every
calendar year over the life of the bond. It is now April 1 and you are worried
about the prospect of rates going lower. You would like to pay floating rates
and receive fixed rates.
In order to keep your balance sheet as "clean" as possible, it is
worthwhile to you to enter into a swap where you will receive fixed rate coupon
payments on the same day that you have to make such payments on your company's
outstanding bond. Therefore, you enter into a delayed start swap.
The delayed start swap is priced using the forward swap curve.
 Recall that the swap curve is
the yield curve used to price interest rate swaps, reflecting both the general
level of risk-free interest rates and the credit spread or swap spread in the
interbank market attributable to the credit risk of default over the life of
the swap.
We can determine the forward yield curve for the risk-free curve using
simple arbitrage. Consider two cases of borrowing for 1 year. In Case A, I
borrow for six months at a known rate and then I rollover my loan for another
six months at the prevailing rate for six months in six months. In Case B, I
borrow for 1 year at a fixed, known rate.
I can simulate a loan lasting six months, starting in six months by
borrowing for one year and simultaneously lending for six months. The forward
rate is the rate I would effectively pay for the six months loan starting in
six months if I were to simulate this loan.
This is the forward rate. It is the rate at which the current yield curve
tells me I can lock in borrowing or lending starting in the future for some
pre-determined period of time.
The Collapsible Swap
There will be times when interest rates are uncertain. Let's say that I
want to enter into a swap but I want to have the right to back out of that swap
if the trend in interest rates changes.
Again, let us say that we believe we are entering into a period of declining
interest rates in which it is preferable to receive fixed rates and pay
floating rates. However, let's say that we are the CFO of a company that is
highly leveraged. We cannot afford to be too wrong about this shift in trend.
Therefore, we enter into a collapsible swap. If interest rates start rising, we
can collapse the swap.
The collapsible swap is simply a combination of a plain vanilla swap with a
swaption on that swap. A swaption is an option on the swap. In this case, the
swaption gives us the right but not the obligation to enter into a swap with
the same terms except that we will be buying fixed rates and receiving floating
rates. The cashflows will offset and the swap will be deemed to be closed out
since the swaption is with the same financial institution with whom we have
contracted the swap.
The Indexed Principal Swap
Up until now, we have been focusing on interest rate swaps (and currency
swaps, etc.) with a fixed notional amount. The indexed principal swap is a
variant in which the principal is not fixed for the life of the option but tied
to the level of interest rates.
Consider an indexed principal swap in which we are obligated to pay fixed
rates and receive floating rates and in which the size of the principal
increases as interest rates decline.
This kind of indexing means that the higher principal pares our risk of
lower interest rates.
Embedding options in the swap accomplishes this payoff structure for us.
By adding an option to the swap that pays us if interest rates fall below a
pre-set level, we can benefit from the decline in interest rates, offsetting
the swap's reduced value should interest rates fall. This can be shown as a
reduced principal on the swap.
These are just a few examples of the kinds of variations on the plain
vanilla swap that financial engineers can construct by adding different
products together. If you can imagine a cash flow, someone can design a product
that mimics that cash flow, albeit with a price attached to it. The question
is, does the value of taking on such a cash flow exceed the price that banks
are willing to charge for designing it?
Increasingly, with transactional costs continuing to diminish in the global
derivatives markets and a greater diffusion of information about such products
comes greater competition and higher volumes.
Article by Chand Sooran, Principal Victory
Risk Management Consulting, Inc.
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