Swaps and OTC derivatives
Domain focus
This domain tests swap mechanics, valuation and OTC documentation. Expect questions on interest rate swaps, currency swaps, credit default swaps, the ISDA Master Agreement and Credit Support Annex (CSA), counterparty risk and collateral.
Core rules
- A plain vanilla interest rate swap exchanges fixed and floating interest on a notional. The notional is not exchanged; only net interest flows.
- At inception, a swap at the market rate has zero value. Later value equals the difference between the present values of the remaining fixed and floating legs; a payer swap can be valued as a floating-rate note minus a fixed-rate bond.
- Currency swaps exchange principal in two currencies at start and end, plus interest; they carry FX and interest rate risk.
- A CDS protection buyer pays a spread; the protection seller pays par minus recovery on a credit event. It is not the same as owning the bond.
- OTC documentation: ISDA Master Agreement, schedule, confirmations and CSA for collateral. Trade reporting, clearing and margin depend on jurisdiction and product.
Worked example
A fund pays fixed 4% on a £50m three-year sterling swap and receives SONIA, with annual payments. After one year, two years remain and the market fixed rate is 3%. Fixed leg PV at 3%: 2/1.03 + 52/1.03² = 1.942 + 49.014 = £50.956m. Floating leg resets to par, £50m. Value to the fixed payer = floating − fixed = 50 − 50.956 = −£0.956m. The fund has a loss because it locked in 4% while market rates fell to 3%.
Traps that cost marks
- Valuing a swap as if the notional changes hands in an interest rate swap.
- Forgetting that swap value is zero at inception only at the market rate.
- Ignoring discounting, day-count conventions and reset timing.
- Treating a CDS as insurance with no counterparty or basis risk.
- Assuming an ISDA Master Agreement guarantees payment; it documents, but the CSA and collateral mitigate credit risk.