Swaps | CHP

Uploaded by HedgeFundGroup on 26.06.2012

In this short video, we will discuss, the fixed for float swap. We will first touch
on defining a swap, and then move on to the components that make up a fixed for float
swap. Our discussion will continue with uses for this derivative product within the capital
markets. Define Swap
A "fixed for float" swap is a derivative product which can be used as a hedging tool against
an adverse movement in a market. The components of a swap include a pricing index such as
a Chicago mercantile exchange futures price which constitutes the floating price for interest
rate products or currencies. A Floating Price is created from the reference index by averaging
the reference prices over the period of the agreed swap. Floating Payments is calculated
by multiplying the floating price by the volume of the underlying asset.
Similar to a futures or stock, there is a buyer and a seller of a swap. One party will
pay a fixed price (similar to buying Apple stock at $600), while the counter party will
receive the fixed price and pay a floating price.
Swap Components Swap Pricing Periods are period of time that
are agreed upon which incorporate the swap. When the swap period is complete the floating
price is examined, and payments are exchanged. Generally monthly periods are used to compute
swaps, but quarterly and annual swaps are also used for computation. This does not mean
the length of the swap is only a month or a quarter, it just means that after each month,
payments are exchanged. For example, two parties can agree on a fixed
for float swap that is 2 years long. After each month the swap payments are calculated
and payments are exchanged. The average floating price over the swap period
is compared to the fixed price, to determine which way cash will flow. (If the fixed price
is lower than the floating price, the fixed price payer received the difference). The
Notional Quantity is the volume of the commodity used to determine the notional value of the
swap. Swap Uses
A swap can be created for an investor or hedger that wants to lock in the price of an asset
reduce some of the price volatility of the product. The consumer for example, is looking
to hedge will fix the asset price to protect against higher prices. The consumer wants
more predictable cash flows in order to determine their ability to manage expenses over the
next month. On each date of the swap, the consumer pays a fixed price for the asset
multiplied by the volume agreed to per day. The counterparty makes a floating payment
based on the arithmetic average of the daily settlement prices of the index that is chosen.
If the CME Eurodollar contract is used as an index, the prompt CME futures contract
for each of the days in the determination period is used as the reference price.
Swaps can also be used as a speculative instrument. A swap rate has an interest rate component
associated with it, which lends itself as a slightly different instrument when compared
to vanilla futures on a commodity. Many market makers sell swaps products and in turn take
swap risk vs. futures risk. Swaps are traded in the over the counter market.
There is an active broker and direct dealer market for swaps on products ranging from
interest rates swaps to commodity swaps. Each type of swap is settled slightly differently.
The International Swaps Dealers Association (ISDA) is used as the governing body that
handles swap issues. ISDA agreements are usually negotiated between counterparties in an effort
to describe how settlements will be paid, and how disruptive events will be handled.
Swaps Clearing Swaps can settle directly through the counterparties
that participate in the transaction, or through a clearing organization. The Chicago Mercantile
Exchange offers swap products which are cleared through its clearing house. The trades themselves
are organized directly through brokers or the counterparties themselves, but are cleared
through the CME. The Chicago Mercantile Exchange, through its
product Clear Port, offers Fixed for Float Swaps on many product. The CME has determined
their settlement proceedures to be: "The final settlement price for a Calendar
Swap is the cumulative average of the daily settlement prices for the next listed, or
“underlying,” futures contract during the month immediately preceding to the Calendar
Swap month. Swaps are a popular and efficient instrument
for hedgers to use to protect against adverse price movements in many markets. Swaps usually
cover a range of dates, and therefore are geared toward hedging risk.