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.