State what function confirmation serves in a swap transaction.
The idea
A confirmation is the document that records the exact terms of one swap trade. These include the parties, notional, trade and effective dates, fixed rate, floating reference rate, payment dates, day count conventions and maturity. It is normally issued under a master agreement, such as the ISDA Master Agreement. The master agreement sets the general terms common to all trades between two parties, including events of default, close-out and netting. Each confirmation forms part of that single agreement. Where the two conflict, the confirmation prevails for that transaction. Its practical purpose is to catch disagreements about terms before the first payment, so it reduces legal and operational risk. It does not remove market risk, and it does not provide collateral, which comes from a separate credit support annex. Exam questions usually ask what the confirmation does or how it relates to the master agreement.
A practice question
What function does the confirmation serve in a swap transaction?
- It hedges the market risk of the swap by fixing the exchange rate or interest rate.Why not: A confirmation documents the trade and does not hedge any risk.
- It sets the floating reference rate that applies to all swaps in the market.Why not: Reference rates are set by the market; the confirmation only names the one used in this trade.
- It guarantees payment by posting collateral against changes in the swap's value.Why not: Collateral comes from a credit support annex, not from the confirmation.
- It is the legal document recording the exact terms of the trade, signed or agreed by both parties. - correct
The confirmation records the notional, dates, fixed rate, floating index, day counts and maturity of one trade, so both sides agree what was traded.
A harder one
A dealer's confirmation of a 5-year swap on USD 50 million shows a fixed rate of 4.25%, while the client's records show 4.15%, and payments are annual. If the discrepancy is not caught, what is the difference in annual fixed payments between the two versions?
- USD 0.50 millionWhy not: Treats 0.10% as 1.0%, an error of a factor of ten.
- USD 0.005 millionWhy not: Treats 0.10% as 0.01%, an error of a factor of ten the other way.
- USD 0.05 million - correct
- USD 0.025 millionWhy not: Halves the difference as if payments were semi-annual.
The difference is 0.10% on USD 50 million = USD 0.05 million per year. Matching confirmations promptly is how such disagreements are caught before they become disputes.
The hardest tier
A dealer has four swaps with one counterparty, all confirmed under one ISDA Master Agreement with close-out netting. The values to the dealer are +USD 4.0 million, minus USD 1.5 million, +USD 2.5 million and minus USD 3.0 million. The counterparty defaults. What is the dealer's exposure, before collateral and recovery?
- USD 2.0 million - correct
- USD 4.0 millionWhy not: Takes the largest single swap value, ignoring the other swaps in the same agreement.
- USD 6.5 millionWhy not: Sums only the positive swaps, ignoring the netting that the master agreement allows.
- USD 4.5 millionWhy not: Sums the absolute value of the negative swaps, which are liabilities that reduce the claim.
Each confirmation forms part of a single agreement, so close-out nets all values: 4.0 - 1.5 + 2.5 - 3.0 = 2.0, a positive claim of USD 2.0 million. This is why confirmations are tied to a master agreement.
In the app: 6 practice questions on this outcome, spaced review that brings it back before you forget it.
Start free →More in Swaps
- Work out the cash flows of a plain vanilla interest rate swap, explaining how it operates.
- Show how a plain vanilla interest rate swap converts an asset or liability into a different one, and work out the cash flows that result.
- Describe how financial intermediaries function in the market for swaps.
- Set out the comparative advantage argument behind interest rate swaps and evaluate some objections to it.
- Describe how a plain vanilla interest rate swap's discount rates are computed.
- Value a plain vanilla interest rate swap as two bond positions held simultaneously.
- Treat a plain vanilla interest rate swap as a strip of FRAs and use that to value it.
- Show how a currency swap converts an asset or a liability into another and compute the cash flows that follow.
- Value a currency swap as two bond positions held simultaneously.
- Use a series of forward exchange rates to value a currency swap.
- Recognise exotic swaps, credit default swaps, volatility swaps and commodity swaps as further types of swap and describe them.
- Outline how credit risk exposure arises for a party holding a swap position.