Financial Modelling 2557A/B Chapter 8: Chapter 8

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Western University
Financial Modelling
Financial Modelling 2557A/B
Xiaoming Liu

Swap: Agreement between 2 parties to exchange cash flows in the future  Introduced for their use in risk management Swap provides mean to hedge a stream of risky payments The party who pays the fixed price and receives the floating price is the "fixed leg"  The counterparty is the "floating leg" Swaps are forward contracts coupled with borrowing and lending  No initial premium Swap specifies maturity date T, notional amount N, and fixed number of periods n The fixed swap rate is as a weighted aberage of the forward prices, where zero-coupon bond prices are used to determine the weights A buyer with seasonally varying demand might enter into a swap, in which quantities vary over time In a plain vanilla interest rate swap, there is maturity date T, notional principal P, and fixed number of periods n  2 parties to the swap  Every period, the fixed leg pays the fixed rate and receives the floating rate payment  The principal is never exchanged
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