In a forward contract, two parties exchange some underlying at a predetermined price at the expiration date. For example, one party agrees to buy a zero-coupon bond for $100 at the expiration date of the contract. Suppose that $100 at expiration is equivalent to 8 percent interest rate. The other party obviously is ready to sell the bond for $100. So, effectively one party that is long bond is short interest rate (as bond prices are indirectly proportional to the price) and the other party that is short bond is long interest rate. The party that is long bond will receive the fixed interest rate of 8 percent from the party that is short bond and effectively paying the floating interest rate that will be on that date. So, in a way, they are swapping fixed interest rate with the floating interest rate. So, the swap contracts are similar to forward contracts. Another similarity is that both forward contracts and swap contracts are traded over the counter.
The swap contracts are different than forward contracts in the sense that the forward contracts have only one settlement (expiration) date but the swaps have multiple settlement (expiration) date. For example, two parties can swap the interest payments of a floating rate coupon paying bond with a fixed rate. One party can receive the fixed rate and pay the floating rate and the other party will pay the fixed rate and receive the floating rate across many settlement dates for the coupon-paying bond. The fixed rate is set at the initiation of the contract and is referred to as swap rate. So, a swap is equivalent to forward contracts, each created at the swap price. Each implicit forward contract is said to be off-market because it is created at the swap price, not the appropriate forward price. It is kind of a replication of many forward contracts.
Check your concepts:
(58.12) A swap contract is equivalent to a series of:
(a) On-market forward contracts, each created at their appropriate forward prices
(b) Off-market forward contracts, each created at the swap price
(c) Off-market forward contracts, each created at their appropriate forward prices
Solution:
(58.12) Correct Answer is B: A swap contract is equivalent to a series of off-market forward contracts, each created at the swap price.
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