There are two ways that a swap position can be interpreted: (1) as a package of forward/ futures contracts, and (2) as a package of cash flows from buying and selling cash market instruments.

Package of Forward Contracts Consider the hypothetical interest-rate swap described earlier to illustrate a swap. Let’s look at party X’s position. Party X has agreed to pay 10% and receive six-month LIBOR. More specifically, assuming a $50 million notional principal amount, X has agreed to buy a commodity called six-month LIBOR for $2.5 million This is effectively a six-month forward contract in which X agrees to pay $2.5 million in exchange for delivery of six-month LIBOR. If interest rates increase to 11%, the price of that commodity (six-month LIBOR) is higher, resulting in a gain for the fixed-rate payer, who is effectively long a six-month forward contract on six-month LIBOR. The floating-rate payer is effectively short a six- month forward contract on six-month LIBOR. There is therefore an implicit forward contract corresponding to each exchange date. Read the rest of this entry »