Hi
I came across this question in Whitney case in CFAI Derivatives topic Test, Q6’s answer says "Interest rate and equity swaps do not involve an exchange of principal. " But in Q2 which is regarding a interest rate swap, the answer includes the exchange of principle at the end. Can anyone explain?
Thanks!
Plain vanilla interest rate swaps (same currency) do not have an exchange of principal; currency swaps (different currencies) do.
If you are VALUING the swap you value each leg as if you exchange principal, although no actual principal is actually exchanged (unless it is a currency swap). For example, if valuing a fixed for floating plain vanilla swap, to value the fixed rate side you would take the PV of each fixed rate payment and the PV of the notional payment using the current term structure. To value the floating rate side you take the next coupon payment (based on previous reset dates interest rate) as well as the notional principal and discount this back at the current rate until it would be recieved. You would then net the two together to get your value.
This is analogous to valuing a fixed rate bond and a floating rate bond.
This may be where your confusion is coming in.
Yes that’s what I thought. But the questions IS regarding a plain vanilla interest rate swap, and they included exchange of principal in their calculations too.
Ok in this case do we also do the same for equity swaps / any other swaps? Coz this can be quite confusing I imagine.
When we price a swap, we use the equivalence of a swap to an exchange of two bonds (which, of course, have principal payments at the end).
When we value a swap, we also use the equivalence to an exchange of bonds, and value the principal at the end for each leg.
When we value an equity swap, we include the value of the principal at the end of the (fixed or floating) leg.
The nice thing about working with swaps is that they all work the same way. We price and value all fixed legs the same way. We value all floating legs the same way. We value all equity legs the same way.
These things are really not too bad to work out. Like you said they are all valued the same way - just find the cash flows and discount back. I guess easier said than done though…
Thanks Magician and bfry. So you’re saying for interest rate swap AND equity swap, we take into account of the exchange of principal when VALUEING them, but NOT really doing the exchange of principal in reality?
Yes the calculation part is quite intuitive, as long as I figure out if principle is invovled or not.
Correct!
Bingo!
Glad to help.
Phew…finally got it right! Thanks a lot 
Cool!