Topic: Settlement Date/Settlement Period/Notional Amount Classmate Explanation:

Question

Topic: Settlement Date/Settlement Period/Notional Amount Classmate Explanation: Swaps involve a series of payments between two parties over a period of time. The settlement date is the date on which the payment between the two parties occurs and the settlement period is the period between the settlement dates. The notional amount is a measure of the size of the swap, which is used to calculate the payments. For example, Joe enters into a interest rate swap with Lucy. The swap has a notional amount of $1 million dollars and payments due on the 15th of January, April, July, and October. The notional amount ($1 million) would be used to calculate the interest payments. In this case, it is different than a principal amount on a loan because it will never be paid or exchanged - it exists solely to calculate the payments of the swap. The settlement dates are the dates payments are due (the 15th of January, April, July and October) and the settlement period is the time between the settlement dates (for example, January 16 to April 14 would be a settlement period). In your own word, please add or deduct from what my classmate have said to make it more clearer to the class

Explanation / Answer

A swap is an agreement between two parties to exchange sequences of cash flows for a set period of time. Usually, at the time the contract is initiated, at least one of these series of cash flows is determined by a random or uncertain variable, such as an interest rate, foreign exchange rate, equity price or commodity price. Conceptually, one may view a swap as either a portfolio of forward contracts, or as a long position in one bond coupled with a short position in another bond.

Unlike most standardized options and futures contracts, swaps are not exchange-traded instruments. Instead, swaps are customized contracts that are traded in the over-the-counter (OTC) market between private parties. Firms and financial institutions dominate the swaps market, with few (if any) individuals ever participating. Because swaps occur on the OTC market, there is always the risk of a counterparty defaulting on the swap.

Plain Vanilla Interest Rate Swap

The most common and simplest swap is a "plain vanilla" interest rate swap. In this swap, Party A agrees to pay Party B a predetermined, fixed rate of interest on a notional principal on specific dates for a specified period of time. Concurrently, Party B agrees to make payments based on a floating interest rate to Party A on that same notional principal on the same specified dates for the same specified time period. In a plain vanilla swap, the two cash flows are paid in the same currency. The specified payment dates are called settlement dates, and the time between are called settlement periods. Because swaps are customized contracts, interest payments may be made annually, quarterly, monthly, or at any other interval determined by the parties.

Plain Vanilla Foreign Currency Swap

The plain vanilla currency swap involves exchanging principal and fixed interest payments on a loan in one currency for principal and fixed interest payments on a similar loan in another currency. Unlike an interest rate swap, the parties to a currency swap will exchange principal amounts at the beginning and end of the swap. The two specified principal amounts are set so as to be approximately equal to one another, given the exchange rate at the time the swap is initiated.

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