Financial news

We have already alluded to the similarity between swaps and assets. For example, a currency swap is identical to issuing a fixed- or floating-rate bond in one currency, converting the proceeds to the other currency, and using the proceeds to purchase a fixed- or floating- rate bond denominated in the other currency. An interest rate swap is identical to issuing a fixed- or floating-rate bond and using the proceeds to purchase a floating- or fixed-rate bond. The notional principal is equivalent to the face value on these hypothetical bonds.
Equity swaps appear to be equivalent to issuing one type of security and using the proceeds to purchase another, where at least one of the types of securities is a stock or stock index. For example, a pay-fixed, receive-equity swap looks like issuing a fixed-rate bond and using the proceeds to buy a stock or index portfolio. As it turns out, however, these two transactions are not exactly the same, although they are close. The stock position in the transaction is not the same as a buy-and-hold position; some adjustments are required on the settlement dates to replicate the cash flows of a swap.
The equivalence of a swap to transactions we are already familiar with, such as owning assets, is important because it allows us to price and value the swap using simple instruments, such as the underlying currency, interest rate, or stock. We do not require other derivatives to replicate the cash flows of a swap. Nonetheless, other derivatives can be used to replicate the cash flows of a swap, and it is worth seeing why this is true.