Template:M intro isda Party A and Party B: Difference between revisions

The first point to make here is that in the real universe of actual, non-synthetic things, ''fixed or floating rate cashflows do exist independently''.<ref>Sure, you could sell a strip of coupons off your bond. Okay. But to do that, there first has to be a bond, and you have to buy it and ''cut it up''. Once you’ve done that, you have your disembodied interest cashflow, but you also have this weird, mutilated principal-only instrument ghosting around the market at a heavy discount to a fully-limbed equivalent, sort of like Weird Barbie or one of those intercised kids without a daemon in ''His Dark Materials''. </ref> They always come attached to an asset of some kind. They are the ''return'' on an investment of principal. In the normal, non-swappist world, to get exposure to a rate in a given “notional amount” is to make a principal investment in that amount. If you want a floating rate on a notional of a hundred bucks, you pony up a hundred bucks and buy a floating rate note.  

It was only once the [[Children of the Woods|Children of the Forest]] wrought their wristy magic on the [[First Men]] in the dark thickets of [[Bretton Woods|Woods of Bretton]] that the ways of the [[Single agreement|Single Agreement]] came into common understanding. Only then were leaden, earth-bound notions of principal swept away; the swap market took wing upon the nuclear power of infinite leverage.

A swap can have disembodied fixed and floating rates only because, when they are set against each other, the principal investments they would normally be attached to ''cancel each other out''. The principal investments are there, but just ''assumed''.  

Again, the key is to consider the respective parties’ economic positions before and after trading. The customer does change its net position; the [[dealer]] does not. Swapping a fixed cashflow for a floating one is to ''keep'' the “asset” that funds that cashflow (which logically must be a “fixed-rate asset”), and to acquire a new floating-rate asset in the same principal amount. This is also the principal amount of the implied loan the customer must take out to acquire the floating-rate asset. That being the case, the principal of the floating-rate asset cancels out against the principal of the loan, and the customer left with just the floating rate cashflows, for which it must pay the fixed rate it has agreed. The customer’s position is the present value of the floating rate it has bought minus the present value of the fixed rate of its financing.