Recognise exotic swaps, credit default swaps, volatility swaps and commodity swaps as further types of swap and describe them.
The idea
Other swaps follow the same exchange-of-cash-flows idea. Exotic interest rate swaps include amortising swaps with a falling notional, accreting swaps with a rising one, forward-start swaps and basis swaps that exchange two floating rates. A credit default swap is a contract in which the protection buyer pays a periodic premium. The seller pays the loss if the reference entity has a credit event. Loss = notional × (1 − recovery rate). A volatility swap exchanges realised volatility for a fixed strike volatility. Payoff = notional per volatility point × (realised volatility − strike). A variance swap pays on variance instead. A commodity swap exchanges a fixed price per unit for a floating price, usually an average of spot prices, on an agreed quantity. A consumer can use it to fix its cost. Match the product to the exposure it hedges.
Formulas
Credit default swap payout
payout = notional × (1 − recovery rate)
- notional
- the amount of protection bought
- recovery rate
- the share of the claim recovered on the reference obligation
Paid by the seller on a credit event. The buyer's net gain also deducts the premiums already paid.
Volatility swap payoff
payoff = notional per point × (realised volatility − strike)
- notional per point
- the amount paid per volatility point
- realised volatility
- volatility measured over the period, in points
- strike
- the fixed volatility agreed at the start, in points
To the party receiving realised volatility. A variance swap pays on variance instead.
A practice question
In a credit default swap, what does the protection buyer do?
- Pays the reference entity's coupons in exchange for its principal at maturity.Why not: Describes a total return exchange or loan purchase, not a credit default swap.
- Receives a periodic premium and pays the seller if the reference entity has a credit event.Why not: Reverses the roles: the protection seller receives the premium and pays on the credit event.
- Exchanges fixed and floating interest payments on the reference entity's debt.Why not: Describes an interest rate swap, not a credit default swap.
- Pays a periodic premium and receives a payment from the seller if the reference entity has a credit event. - correct
In a CDS, the buyer pays the premium (spread) and, on a credit event, receives notional x (1 - recovery rate) from the seller.
A harder one
A volatility swap has a notional of USD 50,000 per volatility point and a strike of 22%. Realised volatility over the period is 26.5%. What is the payoff to the buyer of the swap (the party that receives realised volatility)?
- USD 248,011Why not: Applies the variance swap convention, (realised² - strike²)/(2 x strike), instead of the volatility difference.
- USD 225,000 - correct
- Minus USD 225,000Why not: Reverses the sign: the buyer gains when realised volatility exceeds the strike.
- USD 1,325,000Why not: Multiplies realised volatility by the notional and ignores the strike.
A volatility swap pays notional per point x (realised - strike) = 50,000 x (26.5 - 22.0) = USD 225,000.
The hardest tier
A bank buys 5-year credit protection on USD 20 million at a spread of 120 basis points, with quarterly premiums. After exactly 2 years, immediately after the eighth premium is paid, the reference entity defaults and recovery is 35%. Ignoring discounting, what is the bank's net gain from the CDS (payout minus premiums paid), in USD million?
- 11.08Why not: Treats each quarterly premium as a full year of premium, overstating the premiums paid.
- 13.00Why not: Ignores the premiums paid over the first 2 years.
- 12.52 - correct
- 6.52Why not: Uses the recovery rate instead of the loss rate for the protection payment.
Payout = 20 x (1 - 0.35) = 13.00. Premiums = 8 x 20 x 1.2%/4 = 0.48. Net = 13.00 - 0.48 = 12.52.
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.
- State what function confirmation serves in a swap transaction.
- 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.
- Outline how credit risk exposure arises for a party holding a swap position.