Hi all,Please could someone provide me a definition of a Variable Notional Swap and also examples of it use?I've tried wiki and googling but have'nt found a creditable source which I can trust to use as a definition for a presentation.Many thanks in advance,atms

I only known them as amortising or accrual Swaps. Used in the MBS market due to the structure of mortgages.

QuoteOriginally posted by: rmaxI only known them as amortising or accrual Swaps. Used in the MBS market due to the structure of mortgages.Thanks for the quick answer.If it is convenient for you, please could you expand on the definition and use? (this is all very new to me)Many thanks again,atms

Most mortgages have an amortizing principal schedule. The level periodic mortgage payment can be broken down into interest and principal components (early on mostly interest, later on mostly principal) such that the outstanding loan principal is brought down to zero at the end of the amortization period (i.e. the loan is fully paid off). This amortizing quality means that a typical 30-year mortgage has a much lower duration than a 30-year vanilla (i.e. non-amortizing) interest rate swap. As rmax has noted, amortizing swaps are sometimes used to hedge mortgage products so as to more closely match the interest rate risk.Any good book on swaps (Flavell or Mirron and Swannell) should cover this stuff. But basically, for an amortizing swap the fixed and floating side swap payments are derived using the appropriate rate for each side (the fixed rate for the fixed side and the forecast floating rate for the floating side) and the appropiate notional given by the amortization schedule. Since interest rate swaps are an OTC product they can be highly customized to meet the needs of the end user (that is until central swap clearing and standardization take over!) and the underlying notional amortization schedule can take on pretty much any desired form. Expect to pay more or receive less when asking for non-standard principal amortization schedules.There used to be a product called the Indexed Amortizing Swap that had the notional swap principal indexed to a reference rate of interest. This refinement was intended to capture mortgage prepayment behaviour (more people prepay their mortgages when rates go down, hence the hedge swap notional should go down too). I think this product basically failed when a couple of shops lost big coin trying it.

QuoteOriginally posted by: DavidJNMost mortgages have an amortizing principal schedule. The level periodic mortgage payment can be broken down into interest and principal components (early on mostly interest, later on mostly principal) such that the outstanding loan principal is brought down to zero at the end of the amortization period (i.e. the loan is fully paid off). This amortizing quality means that a typical 30-year mortgage has a much lower duration than a 30-year vanilla (i.e. non-amortizing) interest rate swap. As rmax has noted, amortizing swaps are sometimes used to hedge mortgage products so as to more closely match the interest rate risk.Any good book on swaps (Flavell or Mirron and Swannell) should cover this stuff. But basically, for an amortizing swap the fixed and floating side swap payments are derived using the appropriate rate for each side (the fixed rate for the fixed side and the forecast floating rate for the floating side) and the appropiate notional given by the amortization schedule. Since interest rate swaps are an OTC product they can be highly customized to meet the needs of the end user (that is until central swap clearing and standardization take over!) and the underlying notional amortization schedule can take on pretty much any desired form. Expect to pay more or receive less when asking for non-standard principal amortization schedules.There used to be a product called the Indexed Amortizing Swap that had the notional swap principal indexed to a reference rate of interest. This refinement was intended to capture mortgage prepayment behaviour (more people prepay their mortgages when rates go down, hence the hedge swap notional should go down too). I think this product basically failed when a couple of shops lost big coin trying it.Amazing. Thank you very much

DavidJN - thanks for writing a far more explicit and elegant answer than I could have mustered!

Richard Bookstaber in "A demon of our own design" has a very detailed account of the origins of the index amortizing swap market as well as a fairly accurate description of its downfall, or at least how it contributed to rather large losses at UBS in 1995. The name Sheldon Epstein comes up a lot. You should be able to read the relevant bits for free on Google Books.

I have heard the term used only in a different sense.A customer wants to trade something actively, say the 2 year/10 year yield spread. Instead of writing new OTC swaps for each trade, the dealer creates a shell swap. The customer can change the notional at any time, even reversing direction. Each change is priced at market by the trading desk.In this sense, it's more like a trading account than a swap. As far as I can tell, it's operationally more difficult on the dealer's side, although there are plusses and minuses. I believe they are offered for some customers that perfer them for some reason. Perhaps it's easier for them to account for a single swap with daily P&L than to try to enter hundreds of vanilla swaps into an accounting system not designed for derivatives. Or there may be some regulation or restriction ("Okay, you can trade swaps, but only one!").

Thanks for all the answers, much appreciated.Please could someone explain the following statement made early by DavidJN"This amortizing quality means that a typical 30-year mortgage has a much lower duration than a 30-year vanilla (i.e. non-amortizing) interest rate swap".What does 'lower duration' mean and what significance does it have causing the 30 year mortgage and 30 year vanilla to be different?Many thanks in advance,atms

Your questions really belong in the Student Forum, even a absolute newbie section if there was one.Duration is a measure of risk, the higher the duration the more interest rate risk (all other things equal).Compare two 30-year bonds. One pays a regular semi-annual coupon and the other is a zero coupon bond. They may both have 30-year maturities but they are clearly very different beasts because the coupon-paying bond gives you periodic income whereas you have to wait 30 years before the zero coupon pays you anything. The duration measure is an attempt to facilitate comparison of fixed income securities with differing payment characteristics. In this example the coupon-paying bond will have a much shorter duration than the zero coupon bond. Duration is also a function of principal amortization, the faster the principal amortizes the lower will be duration (all other things equal).Why does this matter? Since a 30-year mortgage has a shorter duration (due to its gradual return of principal) than a 30-year vanilla (that returns no principal until maturity) you need less vanillas to hedge a given notional amount of mortgages. Any basic fixed income text will give you the necessary details. It is time for you to invest in some research and reading.

QuoteOriginally posted by: DavidJNYour questions really belong in the Student Forum, even a absolute newbie section if there was one.Duration is a measure of risk, the higher the duration the more interest rate risk (all other things equal).Compare two 30-year bonds. One pays a regular semi-annual coupon and the other is a zero coupon bond. They may both have 30-year maturities but they are clearly very different beasts because the coupon-paying bond gives you periodic income whereas you have to wait 30 years before the zero coupon pays you anything. The duration measure is an attempt to facilitate comparison of fixed income securities with differing payment characteristics. In this example the coupon-paying bond will have a much shorter duration than the zero coupon bond. Duration is also a function of principal amortization, the faster the principal amortizes the lower will be duration (all other things equal).Why does this matter? Since a 30-year mortgage has a shorter duration (due to its gradual return of principal) than a 30-year vanilla (that returns no principal until maturity) you need less vanillas to hedge a given notional amount of mortgages. Any basic fixed income text will give you the necessary details. It is time for you to invest in some research and reading.Thank you David.