Swaps Overview and Definitions

Overview of Swaps

• Swaps are agreements between two parties (counterparties) to exchange assets or cash flows over a specified period and interval.
• Introduced in the 1980s, swaps allow firms to manage interest rate, foreign exchange, and credit risks.
• Can lead to significant losses, as seen in the 2008-2009 financial crisis involving major institutions like Lehman Brothers and AIG.
• Five types of swaps are discussed:
  • Interest Rate Swaps
  • Currency Swaps
  • Credit Default Swaps (CDS)
  • Commodity Swaps (definition only)
  • Equity Swaps (definition only)

Types of Swaps and Definitions

• Interest Rate Swap:
  • Contract exchanging one stream of future interest payments for another based on a specified principal amount.
• Currency Swap:
  • Exchange of principal amounts and interest payments in different currencies over a given period.
• Credit Default Swap (CDS):
  • Allows investors to swap credit risk; insurance compensation in case of default.
• Commodity Swap:
  • Exchanges cash flows to hedge against market price fluctuations of commodities.
• Equity Swap:
  • Exchanging cash flows enables income diversification while retaining original assets.

Swap Markets

• The swap market is distinct from other derivatives, as they are viewed as a portfolio of forward contracts.
• Major participants include commercial and investment banks as dealers and users.
• Key differences include:
  • Swaps are marked to market only at coupon payment dates, unlike continuously marketed futures/options.
  • High transaction costs are associated, particularly for options.
• Swap dealers manage risk and facilitate liquidity by connecting parties involved in swaps.

Interest Rate Swaps

• A fixed interest rate is exchanged for floating.
• It is the largest segment of the swap market utilized by financial institutions for hedging.
• Plain Vanilla Interest Rate Swaps:
  • Standard agreements without additional features.
• Purpose:
  • Convert variable-rate instruments into fixed-rate and vice versa to align the duration of assets and liabilities.

Example of an Interest Rate Swap

• Money Center Bank (MCB) raised $100 million at a fixed rate while having loans tied to LIBOR (floating rate).
• MCB aims to match its liabilities and assets by using swaps to hedge the duration gap.
  • Metrics:
  • $DA < $DL (negative gap for MCB)
  • Savings Bank has a positive gap.
• Notional value of swap is $100 million with fixed payments of 10%.
• Payment exchanges occur based on LIBOR fluctuations.

Off-Market Swaps

• Custom-tailored swaps are created to fit specific needs. Examples include:
  • Unique interest rates or terms, potentially increasing/decreasing notional values.

Macrohedging with Swaps

• Mitigates systemic risk from a portfolio of assets. Calculation for hedging involves:
  • $ ext{E} = -(DA - kDL)A[rac{ riangle R}{(1 + R)}] > 0$
• Example calculations illustrate determining notional values required for hedging against interest rate changes.

Currency Swaps

• Currency swaps hedge against exchange rate risk by enabling the exchange of principal and interest payments in different currencies.
• Examples demonstrate how U.S. and U.K. banks can structure swaps to benefit both parties by reducing financing costs.

Credit Swaps

• Involves insurance against default, where the seller compensates the buyer if a reference asset defaults.
• Notable types include total return swaps for hedging against credit risk changes.

Swaps and Credit Risk Concerns

• Increased scrutiny and regulation post-financial crisis due to the massive exposure of firms like Lehman Brothers and AIG to credit risk through derivatives.
• The Over-the-Counter Derivatives Market Act of 2009 established new regulations for swap transactions.