Derivatives | Tutorials
Unwinding a Swap
A process of terminating a swap by marking it to market and calculating its value in order to determine which counterparty has a positive terminal value. This counterparty will receive cash payment from the other counterparty whose terminal value is negative. A major technical consideration in unwinds is the stub period. If this period is at the beginning, then it needs to be handled separately. Suppose an investor is a counterparty to a swap with a remaining life of three years and eight months against six-month LIBOR. This gives him six even periods (six months each) and one partial (2 months). First of all, the value of the partial period should be calculated separately, then the present value of the full six periods, as if the stub period didn't exist.
If the notional principal amount of the swap is $10 million, whilst the normal LIBOR rate is 6% and the unwind rate is 5%. Then the partial period will contribute a value of 1% x $10 million x 2/12= 16,666 (approximate number). Thereafter, the present value contributed by the full periods is found using the following specifics:
payment = 50,000, rate = 5%/2 or 2.5%, number of periods = 6
PV of all full periods = 275,406
PV of the swap = PV of all full periods + PV of the partial period
PV of the swap = 275,405 + 16,528
PV of the swap = 291,933
PV of the partial period= 16,666/ (1+ 0.8333%) = 16,528 (roughly), knowing that the interest rate applied to the partial period of 2 months is 5%/6 = 0.8333%
In unwinding a swap with the stub period at the end, the calculation is no different, though it goes the other way around. First, calculate the value of full periods, then the value of the stub and bring it forward. Finally, add up both values, and the resulting figure is the value of the swap.