Swap markets

what is a swap?

Two parties agree to exchange payment obligations on two underlying financial debts that have the same principal but different payment schedules.

interest rate swap:

A forward contract where two parties exchange future interest payments (fixed or floating) based on a specified principal amount to reduce or increase exposure to interest rate fluctuations.

what is the notional principal?

the amount the interest is calculated on, but the actual money is never exchanged.

what are the two main reasons for entering a swap?

To hedge interest rate risk by exchanging fixed rate payments for floating-rate ones
to take advantage of credit risk differentials

what do swap dealers do?

act as the middlemen between two parties in a swap. They take the place of both sides in the deal. They handle many swaps at once (called a book) which they try to keep as closely matched as possible so as to minimise market risk.

Are swap markets more or less regulated than other markets?

less

why do swaps not have a central clearinghouse?

they are too customised and complex to be easily cleared by a central clearinghouse, so they are traded privately between two parties or through dealers.

what are banks required to do to deal with swap risk

banks must keep extra money (capital) set aside to cover possible losses.

what is a credit default swap (CDS) ?

a contract in which a buyer pays a payment to a seller to take on the credit risk of a third party.

What happens is a credit default swap (CDS)?

The buyer receives the right to a payoff from the seller if the third party goes into default or on the occurrence of a specific credit event named in the contract (such as bankruptcy or restructuring)

CDS contracts protect against credit risk of:

Corporate bonds, government bonds, mortgage backed securities

who are the protection buyers in a CDS contract?

mostly banks and financial institutions

who are the protection sellers in a CDS contract?

anybody with an appetite for risk, such as hedge funds and insurance companies.

Who pays the premium in a CDS?

The buyer of the CDS pays regular premiums to the seller to remain insured

in the event of default for a CDS for bonds:

The seller of the CDS pays the face value of the bond to the buyer of the CDS (and receives the bond)

What is a ‘credit event’?

A default, restructuring, or bankruptcy of the bond issuer

What is a CDS spread?

The yearly cost (as a %) the buyer pays for protection, based on the notional bond amount

How are CDSs traded?

OTC, over the counter

What is the benefit of a CDS to a seller

if the underlying borrower may not default which means the seller can make a profit

Why does a buyer purchase a CDS?

To hedge against the risk that a company might default on its bonds.

What guidelines to CDS contracts follow

Most contracts follow standard terms and conditions of the International Swaps and Derivatives Association (ISDA)

A CDS can be purchased even if the buyer…

does not own the debt itself