Module 3: Swaps Pricing and Construction
1. Module Overview
This module introduces swap contracts, how they are structured, and how they are priced. The focus is on understanding how swaps are built from simpler instruments and how they are used to manage interest rate and currency risk.
2. Learning Objectives
By the end of this module, you will be able to:
- Understand what swaps are and how they work
- Identify the main types of swaps (interest rate and currency swaps)
- Explain how swaps are constructed from underlying components
- Understand the basic pricing logic of swaps
3. Core Concepts
3.1 What Is a Swap
A swap is an agreement between two parties to exchange a series of cash flows over time.
Key idea:
A swap allows parties to transform their financial exposure without changing the underlying asset.
3.2 Common Types of Swaps
Interest Rate Swap
- Exchange fixed interest payments for floating interest payments
Example:
Company A pays fixed rate → receives floating rate
Company B pays floating rate → receives fixed rate
Currency Swap
- Exchange cash flows in different currencies
Example:
- Company in Malaysia needs USD
- Company in US needs MYR
→ They swap payments to reduce currency risk
4. Simple Swap Structure (Diagram)
4.1 Interest Rate Swap
Company A Company B
(Pays Fixed) (Pays Floating)
Fixed Rate ----------->
<-----------
Floating Rate
Meaning:
One party pays fixed
One party pays floating
Payments are exchanged periodically
5. How Swaps Are Constructed
A swap can be viewed as a combination of forward contracts.
Swap = Series of Forward Agreements
Explanation:
- Each payment in a swap is like a forward contract
- Together, they form a stream of future exchanges
6. Pricing Logic (Intuition First)
At the start of a swap:
Value of Fixed Payments = Value of Floating Payments
Meaning:
- The swap is priced so that no party has an advantage initially
- The value changes over time as interest rates move
7. Simple Pricing Diagram (Conceptual)
Future Cash FlowsFixed Payments ----------->
<-----------
Floating PaymentsInitial Value = Balanced
Key Insight:
- Swap pricing ensures fairness at the start
- Market movements create gains/losses later