Swaps and Risk Management
Swaps exchange cash flows over time, usually on a notional principal that is not itself exchanged in a plain vanilla interest rate swap. The exam tests swap mechanics, valuation and par rates, plus the risk-management toolkit: hedging, collateral, counterparty exposure and the limits of each measure.
Swap mechanics
In a plain vanilla interest rate swap one party pays fixed and receives floating; the other is the receiver. Payments are netted on scheduled dates, with day-count conventions and a notional defining the cash flows. A currency swap exchanges principal in two currencies and interest in each. A credit default swap transfers credit risk for a spread; a total return swap exchanges total return for a financing leg.
Valuation
A swap is worth the difference between the present values of its two legs; at inception it is zero. The par swap rate equals (1 − DFₙ) divided by the sum of the discount factors. Standardised swaps are centrally cleared and collateralised, and discounting typically uses an overnight risk-free rate such as SONIA, SOFR or €STR following the LIBOR transition.
Worked example
A three-year annual swap has discount factors 0.96, 0.92 and 0.87. Par rate = (1 − 0.87) ÷ (0.96 + 0.92 + 0.87) = 0.13 ÷ 2.75 = 4.73%. A payer agreeing 4.73% fixed has zero initial value; if market rates rise, the payer gains because the fixed leg is now below market, while the receiver loses by the same amount.
Risk management
- Market risk: measured by delta, duration and DV01; hedged with offsetting futures, swaps or options.
- Counterparty credit risk: current exposure plus potential future exposure, mitigated by netting, collateral and clearing; CVA prices it.
- Basis, liquidity, operational and legal risk remain even when market risk is hedged.
- VaR and stress testing quantify potential losses but do not capture tail events fully.
Marks-losing traps
- Treating notional as exposure; exposure is the replacement cost of the swap.
- Assuming clearing eliminates all risk rather than redistributing it to a CCP.
- Confusing payer and receiver direction when rates move.
- Ignoring collateral terms and wrong-way risk in credit exposure.