In a digital swap:
The structured leg pays a coupon which is dependent on the value of an observed index, such as 6 month Euribor. The coupon payouts can be specified differently for a number of ranges of the value of the observed index. That is, you can specify different coupon payments based upon the actual fixing level of the defined underlying index.
For example, the parties can specify that the observed index for the structured leg will be the 6 month Libor. They can then specify that if, on the fixing date, the 6 month Libor is:
Above 0% but less than or equal to 2%, the structured leg will pay a fixed rate of 4% for the coupon period.
Above 2% but less than or equal to 5%, the structured leg will pay a floating rate equal to the 6 month Libor plus a spread of 15 basis points.
Above 5%, the structured leg will pay a floating rate equal to the 6 month Libor plus a spread of 25 basis points.
The other leg pays a fixed or floating rate.
Advantages of a Digital Swap
A digital swap lets the user specifically focus on where an observation variable is likely to fix. In return, the user is able to achieve target investment or funding objectives. In this fashion, digital swaps are similar to range accrual swaps. The main difference is the ability to switch coupon functions according to the fixing level of the underlying variable. Given a fixing level, you can determine what coupon you would like to either receive or pay.
A digital swap can be used by any of the following:
Asset managers looking for an increased yield.
Liability managers looking for a way to reduce funding costs given a view on the likely level of the observation variable.
Given the ease of setting the payout and the huge variety of possible coupons, the structure can be used to build a payoff profile to suit both sides of the investment spectrum.
Pricing a Digital Swap in SDX Interest Rates
When pricing a digital swap in SDX Interest Rates note that:
Besides the standard fields for vanilla swaps, you must also specify the coupon to be paid by the structured leg.
You do this in the Digital Swap Coupon Builder window which is accessed by clicking the Coupon Structuring button. For more information on this window, see Working With the Digital Swap Coupon Builder Window.
In addition, you must also define whether the fixing date for the observed index is to be set:
In advance, i.e., the rate is to be fixed ‹n› days prior to the start of each coupon period and paid at the end of the same period.
This is the default setting.
In arrears, i.e., the rate is fixed ‹n› days prior to the end of the coupon period.
Note that:
The fixing date setting for the observation index is used for all of the coupon payout conditions—both floating and fixed. So, for a fixed payout condition, it setting affects the date on which the LIBOR is observed; for a floating condition, the setting affects not only the LIBOR that is observed but also the LIBOR that is paid (together with any al spread).
This setting controls the fixing dates for all the instrument’s underlying coupons and all of the coupon payout conditions.