Derivatives are assets that derive their value from an underlying asset. A commodity future derives its value from its underlying commodity and is a derivative contract. A swap is a derivative instrument that involves two parties exchanging certain benefits to either hedge their inherent risk or to speculate. Swaps can be based on interest rates, foreign exchange rates, equities and commodity prices.
Swap Contracts
Swaps are initiated with a zero value and their payoffs change as the value of benefits exchanged changes. A notional principal is the amount on which the swap contract is based and is determined at the time of the initiation of a swap contract, it is called a notional principal because the principal is generally not exchanged between the parties except sometimes in the case of currency exchanges.
Calculating Returns to Swaps and Swap Payoffs
Step 1
Determine the notional principal of a swap mentioned in the swap agreement. For this example, suppose a notional principal of $100,000.
Step 2
Find the current rate from an appropriate finance website such as MSN Money, Yahoo! Finance or The Wall Street Journal. In this example, assume an interest rate swap with the current market interest rate at 8%.
Step 3
Calculate the payoff to the swap at the end of the period by taking the difference between the current interest rate and the fixed contract rate to get the floating rate receiver. Assuming a fixed rate of 6% for the swap, the floating rate receiver of the swap benefits by (8 – 6 = 2 %) 2%.
Step 4
Estimate the percentage payoff for the period by multiplying the percentage swap benefits with the portion of the year on which the contract is based. For example, assume a swap contract for 6 months to estimate the the percentage payoff that is [2%* (6/12) = 1%] 1%.
Step 5
Calculate return to the floating rate receiver by multiplying the percentage interest rate benefit with the notional principal. For example, the floating rate payer receives (100,000 * 0.01 = 1,000) $1,000 at the end of the swap period due to a favorable movement of the interest rates.
Things to Remember
A swap has a positive payoff to one party and a negative payoff to the other party. The profit of one party is at the expense of the other party and exactly offsets with a loss to the other party. For a currency exchange, if the principal is exchanged, then both parties bear a default risk, which is non-existent for swap contracts that do not exchange the principal at contract initiation.
Author Paul Nchemba
Swap Contracts
Swaps are initiated with a zero value and their payoffs change as the value of benefits exchanged changes. A notional principal is the amount on which the swap contract is based and is determined at the time of the initiation of a swap contract, it is called a notional principal because the principal is generally not exchanged between the parties except sometimes in the case of currency exchanges.
Calculating Returns to Swaps and Swap Payoffs
Step 1
Determine the notional principal of a swap mentioned in the swap agreement. For this example, suppose a notional principal of $100,000.
Step 2
Find the current rate from an appropriate finance website such as MSN Money, Yahoo! Finance or The Wall Street Journal. In this example, assume an interest rate swap with the current market interest rate at 8%.
Step 3
Calculate the payoff to the swap at the end of the period by taking the difference between the current interest rate and the fixed contract rate to get the floating rate receiver. Assuming a fixed rate of 6% for the swap, the floating rate receiver of the swap benefits by (8 – 6 = 2 %) 2%.
Step 4
Estimate the percentage payoff for the period by multiplying the percentage swap benefits with the portion of the year on which the contract is based. For example, assume a swap contract for 6 months to estimate the the percentage payoff that is [2%* (6/12) = 1%] 1%.
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Step 5
Calculate return to the floating rate receiver by multiplying the percentage interest rate benefit with the notional principal. For example, the floating rate payer receives (100,000 * 0.01 = 1,000) $1,000 at the end of the swap period due to a favorable movement of the interest rates.
Things to Remember
A swap has a positive payoff to one party and a negative payoff to the other party. The profit of one party is at the expense of the other party and exactly offsets with a loss to the other party. For a currency exchange, if the principal is exchanged, then both parties bear a default risk, which is non-existent for swap contracts that do not exchange the principal at contract initiation.
Author Paul Nchemba
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