Vanilla swap

One answer to this problem is for the investor to use a cancellable swap instead of a vanilla swap. Suppose that the investor is interested in a 5-year swap, cancellable by the investor after three years. This can be structured by combining ... 

A 3-year European-style payer s swaption into a 2-year swap, struck at the fixed rate of the vanilla swap. 

A vanilla swap paying 3.00% fixed for five years. 

As discussed above, vanilla swap rates are often quoted as a spread that is a function mainly of the credit spread required by the market over the risk-free government rate. This convention is logical, because government bonds are the principal instrument banks use to hedge their swap books. It is unwieldy, however, when applied to nonstandard tailor-made swaps, each of which has particular characteristics that call for particular spread calculations. As a result, banks use zero-coupon pricing, a standard method that can be applied to all swaps. 

The discussion so far has involved plain vanilla swaps. These have been shown to have the following characteristics ... 

Swaps may also be extendable or putable. In an extendable swap, one of the parties has the right, but not the obligation, to extend the life of the swap beyond the fixed maturity date. In a putable swap, one party has the right to terminate the swap ahead of the specified maturity date. The fixed rate would be adjusted to reflect the cost of the implicit option. For example, if the fixed payer has the right to extend the swap, the fixed rate would be higher than for a plain vanilla swap with similar terms. 

A forward-start swap s effective date is a considerable period—say, six months—after the trade date, rather than the usual one or two days. A forward start is used when one counterparty, perhaps foreseeing a rise in interest rates, wants to fix the cost of a future hedge or a borrowing now. The swap rate is calculated in the same way as for a vanilla swap. 

A vanilla 5-year swap where the investor receives fixed and pays floating. 

This arrangement could be structured as in Exhibit 17.31. This shows the vanilla 5-year swap coupled with the payer s swaption. Unfortunately, the need for the investor to make an up-front payment of 1.29% to acquire the payer s swaption makes the arrangement somewhat untidy. 

The long end of the swap curve is derived directly from observable coupon swap rates. These are generic plain vanilla interest rate swaps with fixed rates exchanged for floating interest rates. The fixed swap rates are quoted as par rates and are usually compounded semiannually (see Exhibit 20.2). The bootstrap method is used to derive zero-coupon interest rates from the swap par rates. Starting from the first swap rate, given all the continuously compounded zero rates for the coupon cash flows prior to maturity, the continuously compounded zero rate for the term of the swap is bootstrapped as follows ... 

FIGURE 7.2 Cash Flows far a Plain Vanilla Intprust Rata Swap... 

FIGURE 7.2 illustrates the cash flows from a plain vanilla interest rate swap, indicating inflows with arrows pointing up and outflows with downward-pointing ones. The net flows actually paid out are also shown. 

Consider a plain vanilla interest rate swap with a notional principal of M that pays n interest payments through its maturity date, T. Payments are made on dates 4 where i = 1,. ..n. The present value today of a future payment made at time r, is denoted as PV 0, t,). If the swap rate is r, the present value of the fixed-leg payments, PVfi s is given by equation (7.2). 

As noted earlier,a newly transacted interest rate swap denotes calculating the swap rate that sets the net present value of the cash flows to zero. Valuation signifies the process of calculating the net present value of an existing swap by setting its fixed rate at the current market rate. Consider a plain vanilla interest rate swap with the following terms ... 

FIGURE 7.5 Pricing a Plain Vanilla Interest Rate Swap ... 

Each of these characteristics can be altered to meet particular customer demands. The resulting swaps are non-plain vanilla, or nongeneric. 

Bond traders wishing to hedge the interest rate risk of their bond positions have several tools to choose from, including other bonds, bond futures, and bond options, as well as swaps. Swaps, however, are particularly efficient hedging instruments, because they display positive convexity. As explained in chapter 2, this means that they increase in value when interest rates fall more than they lose when rates rise by a similar amount—just as plain vanilla bonds do. 

Options price sensitivity is different from that of other financial market instruments. An option contract s value can be affected by changes in any one or any combination of the five factors considered in option pricing models (of course, strike prices are constant in plain vanilla contracts). In contrast, swaps values are sensitive to one variable only—the swap rate—and bond futures prices are functions of just the current spot price of the cheapest-to-deliver bond and the current money market repo rate. Even more important, unlike for the other instruments, the relationship between an option s value and a change in a key variable is not linear. 

The swap payer can reduce or remove credit risk without selling the relevant asset. In a vanilla TR swap, the total return payer retains rights to the reference asset, although, in some cases, servicing and voting rights may be transferred. At swap maturity, the swap payer can reinvest the asset, if it still owns it, or sell it in the open market. The swap can thus be... 

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