at a fixed time in the future. If the agreed interest rate is fixed, say 5 % per year, then the size of the two cashflows is defined from the beginning.
Figure 3.4 depicts our cashflows if we borrow money for future repayment at a fixed interest rate.
Figure 3.4 Cashflows on fixed loan
Some loans can be based on floating rate interest, as in Figure 3.5. This means the parties agree that the interest rate will be based on some reference index plus an agreed margin on top as shown in Figure 3.5. For example, LIBOR plus 200 basis points (one basis point is 0.01 % so 200 basis points is 2 %). The size of the repayment cashflow will not be determined until just before it is due. At a pre-agreed time known as the fixing date (say 11am two business days before repayment is due), the parties will look at the prevailing LIBOR rate (this is a published figure) and determine the size of the repayment. For example:
■ Size of loan: GBP 10,000,000
■ LIBOR rate at fixing: 3.45%
■ Size of repayment will be: 10,000,000 × 5.45 % = GBP 545,000.
Figure 3.5 Cashflows on floating loan
3.4 Deposit
A deposit is, in effect, the opposite of a loan. We give money to the counterparty today and expect the money returned plus interest at some future time. Some deposits attract interim interest at regular periods (annually or semi-annually). Others receive one interest payment at the end. In both cases, the original deposited amount is repaid at the end of the deposit period.
Figure 3.6 shows a deposit with repayment interest at regular intervals and the final receipt for the principal plus the last instalment of interest.
Figure 3.6 Cashflows on deposit with regular repayments
3.5 Swap
The term swap is very general, giving rise to many meanings (e.g. commodity swap, FX swap, credit default swap etc). However, when otherwise unqualified, it is taken as being an interest rate (IR) swap.
The simplest form of interest rate swap is a trade with several pre-defined settlement dates and a nominal notional amount of money that is never exchanged. One side (by convention the buyer) pays a fixed amount on each settlement and the other side pays a floating amount determined by some reference index (such as LIBOR). This is known as a fixed for floating swap (see Figure 3.7). The size and direction of each settlement is unknown at time of transaction. Shortly before each settlement date, the two sides determine the amount to be paid or received by looking at the reference index (a process known as fixing; the date is known as the fixing date).
Figure 3.7 Cashflows on swap trade
For example, the IR swap is defined by:
■ Notional USD 1m.
■ We pay fixed rate of 3 %.
■ We receive float of LIBOR USD 6m rate.
■ Settlement every six months for 2.5 years.
Suppose that just before the first settlement, after the trade has been running six months, a fixing of the reference index (LIBOR USD 6m) is taken and found to be 2.5 %.
So we pay 3 % of 1 million and receive 2.5 % of 1 million. This results in us making a net payment of USD 5000.
Now, at the second settlement after 12 months, suppose the reference index is 3.2 %. Therefore we pay 3 % of 1 million and receive 3.2 % of 1 million. So we receive net USD 2000.
This process continues for each settlement period of the swap.
Common variations are floating-floating and currency swaps. A floating-floating swap is where both sides have a floating amount determined by two different reference indexes. For example, we pay LIBOR USD 3m and received LIBOR USD 6m (the 3m being a different index to the 6m).
A currency swap (not to be confused with an FX or foreign exchange swap) is where the two sides are in different currencies. For example, we pay fixed 3 % of a dollar notional and receive a floating rate in euros based on LIBOR EUR, which is then converted to dollars at the prevailing foreign exchange rate on fixing day to determine the direction and size of settlement.
Although there is always a notional amount in any interest rate swap, this is never actually exchanged. It is only used for determination of amount to be paid or received.
3.6 Foreign exchange swap
Not to be confused with currency swaps, a foreign exchange swap is the exchange of one currency for another now (after a short time for settlement) and the reverse exchange at some point in the future. The dates and amounts in each exchange are agreed and fixed at time of transaction. Figure 3.8 shows an example of this.
Figure 3.8 Cashflows on FX swap trade
In this example, we agree to pay USD 1 million and receive JPY 101 million in two days from now and then to receive USD 1 million and pay JPY 103 million in three months from now.
The USD amounts are the same, but the JPY amounts are different to take into account the difference between USD and JPY interest rates over the next three months. It is very common in foreign exchange swaps that one currency has the same amount exchanged at both times.
The FX swap is in essence a spot foreign exchange trade simultaneously transacted with a future foreign exchange trade.
3.7 Equity spot
A fuller description of equity can be found in section 4.3. For now we will consider an equity trade, which is depicted in Figure 3.9. The purchase of an equity (or share or stock) in a company entitles the buyer to partial ownership of that company. However we need to distinguish from whom we are buying.
Figure 3.9 Cashflows on equity spot trade
If we buy equity directly from the issuing company when it is first issued, we pay cash and receive goods (that is, a share certificate proving the equity entitlement). This is a regular spot trade with the extra consideration of dividends. If the company makes profits, it may decide to distribute them to its shareholders. The time of dividend payments is regular and predictable; the size of the payment is unknown and could sometimes be zero, so we depict it as a dotted line. Note that equity ownership has no maturity. Therefore the potential to receive dividends is everlasting unless the company closes or the shares are sold.
If, on the other hand, we buy equity from a secondary source (such as somebody who bought it directly from the issuing company), the trade is a simple spot trade. Once we have done the trade, our counterparty has no further obligations. It is the purchaser's responsibility to inform the issuing company to transfer
