Question

In no more than 500 words describe with an example of how a swap can be viewed as a portfolio of two bonds.

Answer 1

Swap is a contract where parties agree to exchange a fixed cashflow with a floating cash flow. Parties may enter into a swap transaction where one require a fixed rate although he has a floating rate. Parties may also enter in a swap transaction in order to decrease the overall cost of the capital. Where the parties have cost advantage in one rate but requires to borrow in other scheme than that may give rise to swap transaction.

Suppose A enters in a swap to give fixed rate and receive floating. Such transaction can also be created through bonds. A can buy a floating rate bond through which he would receive floating rate and sell the fixed rate bond where he is obliged to pay fixed.

Hence using a portfolio of 2 bonds, a position similar to swap transaction can be created.