To install click the Add extension button. That's it.

The source code for the WIKI 2 extension is being checked by specialists of the Mozilla Foundation, Google, and Apple. You could also do it yourself at any point in time.

4,5
Kelly Slayton
Congratulations on this excellent venture… what a great idea!
Alexander Grigorievskiy
I use WIKI 2 every day and almost forgot how the original Wikipedia looks like.
What we do. Every page goes through several hundred of perfecting techniques; in live mode. Quite the same Wikipedia. Just better.
.
Leo
Newton
Brights
Milds

Swap (finance)

From Wikipedia, the free encyclopedia

A swap is a derivative in which two counterparties exchange cash flows of one party's financial instrument for those of the other party's financial instrument.[1] The benefits in question depend on the type of financial instruments involved. For example, in the case of a swap involving two bonds, the benefits in question can be the periodic interest (coupon) payments associated with such bonds. Specifically, two counterparties agree to exchange one stream of cash flows against another stream. These streams are called the legs of the swap. The swap agreement defines the dates when the cash flows are to be paid and the way they are accrued and calculated.[2] Usually at the time when the contract is initiated, at least one of these series of cash flows is determined by an uncertain variable such as a floating interest rate, foreign exchange rate, equity price, or commodity price.[2]

The cash flows are calculated over a notional principal amount. Contrary to a future, a forward or an option, the notional amount is usually not exchanged between counterparties. Consequently, swaps can be in cash or collateral.

Swaps can be used to hedge certain risks such as interest rate risk, or to speculate on changes in the expected direction of underlying prices.[3]

Swaps were first introduced to the public in 1981 when IBM and the World Bank entered into a swap agreement.[4] Today, swaps are among the most heavily traded financial contracts in the world: the total amount of interest rates and currency swaps outstanding was more than $348 trillion in 2010, according to Bank for International Settlements (BIS)[5].

Most swaps are traded over-the-counter (OTC), "tailor-made" for the counterparties. Some types of swaps are also exchanged on futures markets such as the Chicago Mercantile Exchange, the largest U.S. futures market, the Chicago Board Options Exchange, IntercontinentalExchange and Frankfurt-based Eurex AG.

The Bank for International Settlements (BIS) publishes statistics on the notional amounts outstanding in the OTC derivatives market. At the end of 2006, this was USD 415.2 trillion, more than 8.5 times the 2006 gross world product. However, since the cash flow generated by a swap is equal to an interest rate times that notional amount, the cash flow generated from swaps is a substantial fraction of but much less than the gross world product—which is also a cash-flow measure. The majority of this (USD 292.0 trillion) was due to interest rate swaps. These split by currency as:

The CDS and currency swap markets are dwarfed by the interest rate swap market. All three markets peaked in mid-2008.Source: BIS Semiannual OTC derivatives statistics at end-December 2008
The CDS and currency swap markets are dwarfed by the interest rate swap market. All three markets peaked in mid-2008.
Source: BIS Semiannual OTC derivatives statistics at end-December 2008
Currency Notional outstanding (in USD trillion)
End 2000 End 2001 End 2002 End 2003 End 2004 End 2005 End 2006
Euro 16.6 20.9 31.5 44.7 59.3 81.4 112.1
US dollar 13.0 18.9 23.7 33.4 44.8 74.4 97.6
Japanese yen 11.1 10.1 12.8 17.4 21.5 25.6 38.0
Pound sterling 4.0 5.0 6.2 7.9 11.6 15.1 22.3
Swiss franc 1.1 1.2 1.5 2.0 2.7 3.3 3.5
Total 48.8 58.9 79.2 111.2 147.4 212.0 292.0
Source: "The Global OTC Derivatives Market at end-December 2004", BIS, [1], "OTC Derivatives Market Activity in the Second Half of 2006", BIS, [2]

Usually, at least one of the legs has a rate that is variable. It can depend on a reference rate, the total return of a swap, an economic statistic, etc. The most important criterion is that it comes from an independent third party, to avoid any conflict of interest. For instance, LIBOR is published by Intercontinental Exchange.

YouTube Encyclopedic

  • 1/5
    Views:
    565 575
    186 207
    34 890
    1 127
    51 951
  • Credit default swaps | Finance & Capital Markets | Khan Academy
  • Interest Rate Swaps With An Example
  • Use cases for credit default swaps | Finance & Capital Markets | Khan Academy
  • Total Return Swaps by Passing Score
  • CDS and Synthetic CDOs Explained

Transcription

Let's say that I'm a pension fund, and I have money to lend to other people. And I want to lend it to other people, because that way I can get interest on it instead of it just kind of sitting and doing nothing. And if I lend it to someone other than the government, I'll get better interest. So let's say that there's-- so let me draw me, I'm the pension fund. Maybe I'll drawn me in magenta. So that's me, pension fund. And let's say that there's some corporation, let's say it's GM. They make cars. I think you've heard of them. Some corporation, GM. Let's just call it Corporation A. They need to borrow money, maybe to buy a factory or to do something else, we're not going to get involved in what they need the money for. And I'd like to lend them the money. But there's an issue here. I am a pension fund. I manage the retirement fund for the teachers of California, or for the auto workers of Michigan, or whatever. And part of my charter says that I can only invest in very, very, very safe instruments. So I'm not allowed to go gamble people's money, because this is people's retirement. So I can't do very fancy things with it. I can only invest in things that are rated AAA, or let's say AA. I'm just kind of making this up on the fly. So AAA would be like the highest rated securities, right? These are things that have a very low chance of default. But Corporation A is only rated, I don't know, let's say it's rated BB. And actually, this is a good time to think about well who is doing all these ratings. And you might think, oh, it surely is a government entity, because only the government would be objective enough give all of these corporations frankly objective ratings. But unfortunately, it's not. They're private entities, that are actually paid to rate things. And I think I touched on it in the video on collateralized debt obligations. But their incentives are a little bit strange. Let's say I have Moody's. Moody's is one of the ratings agencies, and they rate Corporation A as BB. So they've said, these guys, they're pretty good, but they're not the U.S. government or something. There's a chance that they can go under, for whatever reasons, or they're sensitive to the economy as a whole. And I say, man, I would love to lend these guys money. I would love to lend these guys the $1 billion that they need. And these guys are willing to pay me 8% interest. But I can't do it, me as a pension fund, I cannot lend them money. Because I'm only allowed to lend money to A or above types of bonds. Or I can only buy A or above type of instruments. So what do I do? This guy needs money. I have money to give him, but his corporate credit rating, that was given by Moody's, just isn't high enough for me to lend him the money. And this is where credit default swaps come in. In an ideal world, I would give Corporation A, I would give them $1 billion. And then maybe they would annually give me, let me make up a number, 10% per year. And then this might have a term for 10 years, and then after 10 years, they'll pay me the $1 billon back and then I'll be happy. But as I said multiple times, I can't do it, because they are BB rated. And my charter says I can only invest in A rated bonds. So I go to another entity. And let's call this entity AIG. And these entities are essentially insurance companies on debt. And I'm calling this one AIG because AIG actually did do this. But it could be anything. A lot of banks did this, a lot of insurance companies did this. There are some companies that just specialize in writing collateralized-- sorry, in writing credit default swaps. What does AIG do for me? Well first of all, it's important to note that Moody's has given AIG, I don't know, let's give it a AA rating. I don't know what their actual rating was. They said, you know what, they are almost risk-free. They're almost like the U.S. government. Moody's has looked at their books, or supposedly, or hopefully has looked at their books, and says, oh you know, if you loan them money, they're good for it. So they have a very, very high rating. Although, once again, you have to worry about the incentive. Because who paid Moody's to give them that rating? And whenever you're getting paid to give a rating, you have to wonder about what your incentives are, in terms of how you rate things. But anyway that's a discussion for another video. But what AIG says is, you know what pension fund? I know you want to lend Corporation A money, and Corporation A wants to borrow money from you, but you have this problem because they're BB rated. So what we're going to do is we're going to insure this bond. We're going to insure this loan that you're giving to Corporate B. What we want in return for that is an insurance premium. We want you to pay us a little bit of this interest every year. If you pay us a little bit of this interest every year, we will insure this payment. So you get 10% a year, and you give us 1% a year. So you give us 1% a year. And this is also 1%-- just to learn a little bit of financial jargon-- this is also someone would say 100 basis points. One basis point is 1/100th of 1%. So 1% of the same thing as 100 basis points. 2% is the same thing as 200 basis points. So you pay me 100 basis points of the 10% per year, and in exchange, I will give you insurance on A's debt. And in fact, it might have not even been structured this way. It might have been structured so that Corporation A right here, before even issuing the bonds, they include this insurance with the bond. So instead of giving 10%, they cut out 1% to insure it. And then these essentially become AA bonds. And why is that? Well, they're BB, but you're being insured by someone who is AA. So all of the sudden, these bonds, because they're being insured by this entity that is AA, which Moody's has determined is AA, these bonds are now good enough for my pension fund to hold. Because I said, you know what even if corporation A goes under, I have this AA guy insuring it. And so I'm fine. So this is the equivalent of holding AA bonds. And what's my effective interest rate? I'm getting 9% per year, right? I'm getting 10% per year from Corporation B, and then I have to pay 1% to AIG. And if Corporation B goes under tomorrow, AIG is going to give me my $1 billion back. And you might say, Sal, this sounds like a pretty good situation. And this is where it starts to get a little bit shady. Because AIG, they're not just insuring my debt or my loan that I gave to corporation A. And think about it, AIG didn't have to do anything. AIG didn't have to put up any collateral. AIG didn't say, you know what, out of all of our assets, here is $1 billion that we're going to set aside, just in case Corporation A doesn't pay. Right? You would think that if you wanted to be guaranteed that this money was going to come to you, this AIG corporation would have to set aside the money. But they didn't have to do that. They just have to say, hey, Moody's has said we're AA, we're good for debt. We're good for insurance. So you just pay us 1% a year and trust us, or trust Moody's, that we really are good for the money. They never had to set aside the money. You're just going on a leap of faith that, if and when Corporation A defaults, AIG is going to be good for the money. Now this is where it gets interesting. Let me erase Moody's from the screen-- actually, maybe I'll go down here. AIG didn't just insure my debt. Let's say that there is Corporation C's debt. Let's say that they're B-- I don't know, all these ratings have different terminology. They're B+ rated. Right? And let's say there's $10 billion of debt that they borrow from some other party. And in return, they give 11%. And this is Pension Fund B. And this pension fund had the same problem. They can only buy A-rated or above bonds. AIG also insures their debt that they gave to Corporation C. Maybe they'll pay them-- Corporation C is maybe a little bit riskier, so out of the 11% I have to pay maybe 150 basis points. Or 1 and 1/2%, that's the same thing as 1%. And in exchange, they insure C's debt. Now something very interesting can happen here. AIG all of the sudden has an excellent business model, right? Because they were able to get this AA rating from Moody's, they can just keep insuring other people's debt, and they don't have to put any money aside, right? They don't have to give their assets to anyone else. And they just get these income streams, right? From my pension fund they're getting 1% per year of $1 billion. From this pension fund, they're getting 1 and 1/2%, 150 basis points, per year. And they can do this, frankly, as much as they want. They could do this a thousand times. And as long as Moody's doesn't get suspicious. As long as Moody's doesn't start saying, hey, wait a second, AIG, you only have $100 billion in assets, but you have insured $1 trillion of other people's debt. Something shady going on, I'm going to lower your rating. As long as that doesn't happen, this AIG corporation can just keep insuring more and more debt. And frankly, as long as none of that debt goes bad, they just get this excellent income stream, and their CEO will get excellent bonuses. I think you start to see where you're having a single point of failure and a house of cards, and I'll continue that in the next video.

Contents

Size of market

As the International Finance in Practice box suggests, the market for currency swaps developed first. Today, however, the interest rate swap market is larger. Size is measured by notional principal, a reference amount of principal for determining interest payments. The exhibit indicates that both markets have grown significantly since 2000, but that the growth in interest rate swap has been by far more dramatic. The total amount of interest rate swaps outstanding increased from $48,768 billion at year-end 2000 to $349.2 trillion by year-end 2009, an increase of 616%. Total outstanding currency swaps increased 417%, from $3,194 billion at year-end 2000 to over $16.5 trillion by year-end 2009.[citation needed]

Swap bank

A swap bank is a generic term to describe a financial institution that facilitates swaps between counterparties. A swap bank can be an international commercial bank, an investment bank, a merchant bank, or an independent operator. A swap bank serves as either a swap broker or swap dealer. As a broker, the swap bank matches counterparties but does not assume any risk of the swap. The swap broker receives a commission for this service. Today, most swap banks serve as dealers or market makers. As a market maker, a swap bank is willing to accept either side of a currency swap, and then later on-sell it, or match it with a counterparty. In this capacity, the swap bank assumes a position in the swap and therefore assumes some risks. The dealer capacity is obviously more risky, and the swap bank would receive a portion of the cash flows passed through it to compensate it for bearing this risk.[citation needed]

Swap market efficiency

The two primary reasons for a counterparty to use a currency swap are to obtain debt financing in the swapped currency at an interest cost reduction brought about through comparative advantages each counterparty has in its national capital market, and/or the benefit of hedging long-run exchange rate exposure. These reasons seem straightforward and difficult to argue with, especially to the extent that name recognition is truly important in raising funds in the international bond market.

The two primary reasons for swapping interest rates are to better match maturities of assets and liabilities and/or to obtain a cost savings via the quality spread differential (QSD). In an efficient market without barriers to capital flows, the cost-savings argument through a QSD is difficult to accept. It implies that an arbitrage opportunity exists because of some mispricing of the default risk premiums on different types of debt instruments. If the QSD is one of the primary reasons for the existence of interest rate swaps, one would expect arbitrage to eliminate it over time and that the growth of the swap market would decrease. Thus, the arbitrage argument does not seem to have much merit. Consequently, one must rely on an argument of market completeness for the existence and growth of interest rate swaps. That is, all types of debt instruments are not regularly available for all borrowers. Thus, the interest rate swap market assists in tailoring financing to the type desired by a particular borrower. Both counterparties can benefit (as well as the swap dealer) through financing that is more suitable for their asset maturity structures.[citation needed]

Types of swaps

The five generic types of swaps, in order of their quantitative importance, are: interest rate swaps, currency swaps, credit swaps, commodity swaps and equity swaps. There are also many other types of swaps.

Interest rate swaps

A is currently paying floating, but wants to pay fixed. B is currently paying fixed but wants to pay floating. By entering into an interest rate swap, the net result is that each party can 'swap' their existing obligation for their desired obligation. Normally, the parties do not swap payments directly, but rather each sets up a separate swap with a financial intermediary such as a bank. In return for matching the two parties together, the bank takes a spread from the swap payments.
A is currently paying floating, but wants to pay fixed. B is currently paying fixed but wants to pay floating. By entering into an interest rate swap, the net result is that each party can 'swap' their existing obligation for their desired obligation. Normally, the parties do not swap payments directly, but rather each sets up a separate swap with a financial intermediary such as a bank. In return for matching the two parties together, the bank takes a spread from the swap payments.

The most common type of swap is an interest rate swap. Some companies may have comparative advantage in fixed rate markets, while other companies have a comparative advantage in floating rate markets. When companies want to borrow, they look for cheap borrowing, i.e. from the market where they have comparative advantage. However, this may lead to a company borrowing fixed when it wants floating or borrowing floating when it wants fixed. This is where a swap comes in. A swap has the effect of transforming a fixed rate loan into a floating rate loan or vice versa.

For example, party B makes periodic interest payments to party A based on a variable interest rate of LIBOR +70 basis points. Party A in return makes periodic interest payments based on a fixed rate of 8.65%. The payments are calculated over the notional amount. The first rate is called variable because it is reset at the beginning of each interest calculation period to the then current reference rate, such as LIBOR. In reality, the actual rate received by A and B is slightly lower due to a bank taking a spread.

Currency swaps

A currency swap involves exchanging principal and fixed rate interest payments on a loan in one currency for principal and fixed rate interest payments on an equal loan in another currency. Just like interest rate swaps, the currency swaps are also motivated by comparative advantage. Currency swaps entail swapping both principal and interest between the parties, with the cashflows in one direction being in a different currency than those in the opposite direction. It is also a very crucial uniform pattern in individuals and customers.

Commodity swaps

A commodity swap is an agreement whereby a floating (or market or spot) price is exchanged for a fixed price over a specified period. The vast majority of commodity swaps involve crude oil.

Subordinated risk swaps

A subordinated risk swap (SRS), or equity risk swap, is a contract in which the buyer (or equity holder) pays a premium to the seller (or silent holder) for the option to transfer certain risks. These can include any form of equity, management or legal risk of the underlying (for example a company). Through execution the equity holder can (for example) transfer shares, management responsibilities or else. Thus, general and special entrepreneurial risks can be managed, assigned or prematurely hedged. Those instruments are traded over-the-counter (OTC) and there are only a few specialized investors worldwide.

Other variations

There are myriad different variations on the vanilla swap structure, which are limited only by the imagination of financial engineers and the desire of corporate treasurers and fund managers for exotic structures.[2]

  • A total return swap is a swap in which party A pays the total return of an asset, and party B makes periodic interest payments. The total return is the capital gain or loss, plus any interest or dividend payments. Note that if the total return is negative, then party A receives this amount from party B. The parties have exposure to the return of the underlying stock or index, without having to hold the underlying assets. The profit or loss of party B is the same for him as actually owning the underlying asset.
  • An option on a swap is called a swaption. These provide one party with the right but not the obligation at a future time to enter into a swap.
  • A variance swap is an over-the-counter instrument that allows one to speculate on or hedge risks associated with the magnitude of movement, a CMS, is a swap that allows the purchaser to fix the duration of received flows on a swap.
  • An Amortising swap is usually an interest rate swap in which the notional principal for the interest payments declines during the life of the swap, perhaps at a rate tied to the prepayment of a mortgage or to an interest rate benchmark such as the LIBOR. It is suitable to those customers of banks who want to manage the interest rate risk involved in predicted funding requirement, or investment programs.
  • A Zero coupon swap is of use to those entities which have their liabilities denominated in floating rates but at the same time would like to conserve cash for operational purposes.
  • A Deferred rate swap is particularly attractive to those users of funds that need funds immediately but do not consider the current rates of interest very attractive and feel that the rates may fall in future.
  • An Accreting swap is used by banks which have agreed to lend increasing sums over time to its customers so that they may fund projects.
  • A Forward swap is an agreement created through the synthesis of two swaps differing in duration for the purpose of fulfilling the specific time-frame needs of an investor. Also referred to as a forward start swap, delayed start swap, and a deferred start swap.

Valuation

The value of a swap is the net present value (NPV) of all estimated future cash flows. A swap is worth zero when it is first initiated, however after this time its value may become positive or negative.[2] There are two ways to value swaps: in terms of bond prices, or as a portfolio of forward contracts.[2]

Note that the discussion below is representative of pure rational pricing; however, insofar as it excludes credit risk, it is somewhat idealized. Current practice - i.e. since the 2007–2012 global financial crisis - is to price swaps under a "multi-curve" framework; see Interest rate swap #Valuation and pricing for formulae, and Financial economics #Derivative pricing for context.

Using bond prices

While principal payments are not exchanged in an interest rate swap, assuming that these are received and paid at the end of the swap does not change its value. Thus, from the point of view of the floating-rate payer, a swap is equivalent to a long position in a fixed-rate bond (i.e. receiving fixed interest payments), and a short position in a floating rate note (i.e. making floating interest payments):

From the point of view of the fixed-rate payer, the swap can be viewed as having the opposite positions. That is,

Similarly, currency swaps can be regarded as having positions in bonds whose cash flows correspond to those in the swap. Thus, the home currency value is:

, where is the domestic cash flows of the swap, is the foreign cash flows of the LIBOR is the rate of interest offered by banks on deposit from other banks in the eurocurrency market. One-month LIBOR is the rate offered for 1-month deposits, 3-month LIBOR for three months deposits, etc.

LIBOR rates are determined by trading between banks and change continuously as economic conditions change. Just like the prime rate of interest quoted in the domestic market, LIBOR is a reference rate of interest in the international market.

Arbitrage arguments

As mentioned, to be arbitrage free, the terms of a swap contract are such that, initially, the NPV of these future cash flows is equal to zero. Where this is not the case, arbitrage would be possible.

For example, consider a plain vanilla fixed-to-floating interest rate swap where Party A pays a fixed rate, and Party B pays a floating rate. In such an agreement the fixed rate would be such that the present value of future fixed rate payments by Party A are equal to the present value of the expected future floating rate payments (i.e. the NPV is zero). Where this is not the case, an Arbitrageur, C, could:

  1. assume the position with the lower present value of payments, and borrow funds equal to this present value
  2. meet the cash flow obligations on the position by using the borrowed funds, and receive the corresponding payments - which have a higher present value
  3. use the received payments to repay the debt on the borrowed funds
  4. pocket the difference - where the difference between the present value of the loan and the present value of the inflows is the arbitrage profit.

Subsequently, once traded, the price of the Swap must equate to the price of the various corresponding instruments as mentioned above. Where this is not true, an arbitrageur could similarly short sell the overpriced instrument, and use the proceeds to purchase the correctly priced instrument, pocket the difference, and then use payments generated to service the instrument which he is short.

See also

References

  • Financial Institutions Management, Saunders A. & Cornett M., McGraw-Hill Irwin 2006
  1. ^ "What is a swap?". Investopedia. Retrieved 14 October 2017. 
  2. ^ a b c d e John C Hull, Options, Futures and Other Derivatives (6th edition), New Jersey: Prentice Hall, 2006, 149
  3. ^ "Understanding Derivatives: Markets and Infrastructure - Federal Reserve Bank of Chicago". chicagofed.org. Retrieved 23 September 2017. 
  4. ^ Ross, Westerfield, & Jordan (2010). Fundamentals of Corporate Finance (9th, alternate ed.). McGraw Hill. p. 746. 
  5. ^ "OTC derivatives statistics at end-June 2017". www.bis.org. 2017-11-02. Retrieved 2018-07-16. 

External links

This page was last edited on 18 September 2018, at 02:58
Basis of this page is in Wikipedia. Text is available under the CC BY-SA 3.0 Unported License. Non-text media are available under their specified licenses. Wikipedia® is a registered trademark of the Wikimedia Foundation, Inc. WIKI 2 is an independent company and has no affiliation with Wikimedia Foundation.