As swap are traded on the over the counter markets, it is compulsory to deal with the historical reasons and conditions that foster the appearance of the modern forms of OTC derivatives, because since the 15th century existed some types of agreements similar to OTC derivatives which were used in the form of forward sales of agricultural goods. Three are the sources that boost the development of the OTCs: economic incentives, including the need to share and hedge the risk, restrictions on financial activity, regarding investment restrictions, regulation and taxation of financial transactions; and the internationalization of finance and the associated methodological advances. Three examples illustrating the use of OTC derivatives show how these incentives formed OTC markets. First, the market for interest rate swaps arise from a desire to exploit differential interest rate advantages for borrowing at fixed versus floating rates. For instance, suppose a low rated bank has to pay 80 basis points more than a high rated bank when borrowing at fixed rates, while it has to pay only 15 basis points more than the high rated bank when borrowing at floating rates. In this case, the two banks could profit from each other's comparative advantage: the low rated bank would borrow at floating rates, the top rated bank instead could borrow at fixed rates, and both bank would exchange the cash flows. These types of transactions gave rise to the interest rate swap market. At the beginning, financial institutions served as brokers helping the counterparties to complete swaps by providing introduction and guidance in the negotiation of the swap. This activity afterwards evolved into the current OTC derivatives markets in which investment and commercial banks actively manage and trade large swap portfolios. Interest rate swaps nowadays account for more than two thirds of OTC derivatives markets activity interest rate contracts.(BIS June 2009). Second, consider the market for currency swaps. These derivatives grew out of a need by multinationals to make foreign currency investments in the period when policy measures were designed to deter capital outflows. For example, the UK government imposed taxes on the sterling foreign exchange transactions. As a consequence the borrowing cost was higher in London than in New York. Then multinational companies set up parallel loans to dodge tax and lessen the cost to UK companies of borrowing dollars. These arrangements avoided the tax on foreign exchange transactions, because the US and UK companies borrowed and lent dollars in the U.S.A and sterling in the UK. The modern currency swap market evolved as companies were seeking to engage in these transactions and applied to the financial institutions to find overseas counterparties with matching needs. Third, consider the market for credit derivatives. This kind of financial instruments allows financial institution to tailor the credit risk to their risk profiles and rise the efficiency of their capital. For instance, by using a credit derivatives the holder of a sovereign bond can immunize the risk of sovereign default and retain the interest rate and the currency risk.
1.2 Development of swap market
The last 30 years have witnessed a blossom of financial innovations . Of the many important innovations, none can equal the burgeoning of the global swap market. A swap is an agreement between two parties to exchange cash flows in the future. The settlement defines the dates when the cash flows have to be paid and the way in which they are to be computed. The outstanding development of the swap market from the 1980s has rendered swaps onwards into some of the most durable tools for risk management, as well as for hedging needs.
The forerunner of the current swaps are considered to be the parallel loans, which were set up by UK and US companies in the 1970s. However, a kind of currency swap transactions involving foreign currencies was arranged between the Bank for International Settlement and the key central banks. These transactions provide for a spot sale or purchase of a currency along with a settlement to buy or sale the currency at some future date. This network was aimed at generating reserves in order to promote the stability of the international monetary system. The exchange controls in the UK in the 1970s fostered the development of parallel loans as means by which UK companies could evade the premium on investment abroad. These financing agreements evolved into the first currency swap in 1976 between ICI Finance of the UK and BOS Kalis Westminster of Holland, which was arranged by Goldman Sachs and Continental Illinois Limited. However, the currency swap became an established instrument of the international financial markets since 1981. The success of interest rate swap market indeed was in 1982 when a US$ 300 million seven year Deutsche Bank bond issue was swapped into a synthetic US$ floating rate note. The first credit default swap was introduced in 1995 by JP Morgan, although other kind of bond insurance products have been since the 1970s.
So the swap market has expanded for more than 15 years at a phenomenal growth rate and it is still evolving, with new sophisticated and innovative solutions of financial engineering . In 2009, as BIS reports in the quarterly Review June 2010, swap contracts represent more than two thirds of the OTC derivatives with a notional amount of 349,236 billions of dollars.
CHAPTER 2 : LITERARY REVIEW
2.1. Differences between swaps market and the regulated markets, concerning futures, options
In a world characterized by fluctuations and volatile rates, the limitation of existing techniques to cope with diverse types of risk has resulted in the development of new products, such as futures and options written on various underlying activities, and financial swaps. Financial swaps differ from futures and options in many important ways. In first place the futures and options markets are regulated by the exchanges where trading takes place, in particular Commodity Futures Trading Commission as far as the futures market and Security Exchange Commission regarding the options market. The options and futures contracts highly standardized contracts, plus the options traded on exchanges include very detailed contract terms that cannot be altered. Moreover, they trade over a shorter horizon than the risk horizon that business face.
The swap market has appeared because swaps avoid many of the limitations concerning futures and exchange traded options markets. Swap are customized to the needs of the counterparties: in fact parties in a swap can design their own contract, which may extend over a period of many years to meet each other's specific expectations, they can choose the exact maturity that they wish, rather than being compelled to fit their needs to the offerings available on a exchange. In addition the swap market allows a privacy that cannot be obtained on futures or options exchanges because only the counterparties know that the agreement takes place. While the futures and options are subject to government regulation, the swap market is virtually free of a regulatory framework. However we have to acknowledge that this market is being regulated by a joint effort of the governmental institutions (US government and EU in primis) in response to the international recession, requiring more transparency, a regulation of dealers and swap market participants, restrictions on swap trading by banks and increased capital and margin requirements.
The swap market also presents some limitations. Firstly, the completion for a swap transaction need a potential participant to have to find another counterparty that is willing to take the opposite side of the transaction. In many cases this process can be difficult especially if one party needs a specific pattern of cash flows, a certain maturity and an acceptable credit standing. Secondly, as a swap is about a contract which bound the counterparties until the maturity, it is not allowed to be altered or terminated early without the consensus of both parties. Furthermore, the exchanges for options and futures secure performance on the contracts for the parties involved, the swap market instead, due to its nature, has not any clearing houses. As a result, parties to the swap have to assess carefully the creditworthiness of their counterparties.
As we shall see later in this project, the swap market has created solutions to handle these three limitations.
2.2 Swap facilitators: brokers, dealers
In order to understand how transactions work, it is compulsory distinguish between two figures, the swap brokers and the swap dealers.
A swap broker arises from the difficulty of finding counterparties with matching needs creates an opportunity. This financial intermediary holds several firms in her client base and is ready to seek swap counterparties on demand, serving as an information facilitator. The party, which is looking for a counterparty that is supposed to meet a number of conditions, would count on the swap broker's specialized knowledge of the swap needs of many companies. Once the party seeks assistance of a swap broker, the ladder starts getting in touch with potential counterparties until he finds a suitable counterparty. The facilitator then lends a support in negotiating and completing a swap contract and receives a fee from each of the counterparties for the service.
A swap dealer as well as providing the services of the swap broker, he acts as a party to the swap contract, which means this kind of intermediary takes a risk position in the swap transaction. In this way we shall state that a swap dealer fulfills all of the functions of a swap broker. The swap decides to bear financial risk in order to complete the transaction for the initial counterparty and then he has to try to offset that risk by its own further transactions.
Let's suppose a plain vanilla interest swap , in which Party 1 is a bank that pays a floating rate of LIBOR plus 150 basis points to its depositors and arranges a five-year fixed rate mortgage loan at 13 percent. Initially Party 1 is exposed to rising interest rates and then Party 1 decides to offset that risk by engaging in a swap, in which it pays 13 percent fixed rate on a notional principal of 20 million $ for the floating rate of LIBOR plus 2.8 percent. If a counterparty as Party 2 cannot be found, Party 1 is unable to complete the swap. Therefore, in order to complete the swap transaction for Party 1, a swap dealer may intervene by acting as a counterparty. As a consequence of this transaction, the swap dealer has an unwanted risk position, because the ladder is bound to pay a floating rate of LIBOR plus 2.8 percent and receive a fixed rate of 13 percent. To make money by acting as a counterparty to Party A, the swap dealer wants to offset the undertaken risk. Let's assume that the dealer knows of a potential party in the swap market, Party 3, which is willing to pay a floating rate for LIBOR plus 3 percent for a fixed rate of 13 percent on a notional principal of 20 million. At this point the swap dealer decides to act as a counterparty to Party 1 and by transacting even with Party 3 he is able to offset all the risk he takes with Party 1. Once completed these transactions, the swap dealer will make a 0.2 percent profit on the floating rate side of the swap because he pays LIBOR plus 2.8 percent and he receives LIBOR plus 3 percent.
2.3. Risks
Financial risks fit into two categories: the market risk and credit risk.
The first type of risk arises from the possibility that market variables, such as interest rates, exchange rates will move in a way that value of the swap becomes negative to one party . These variations are implied in contract's completion and execution and they depend on the market conditions. The intermediary will try to expose as to avoid the undesired situations, in particular the expected market fluctuations are used to profit from the stipulated contract. The risk profile setting up occurs considering the whole portfolio and not only one contract, so that you can identify the elementary risk factors and you can analyze that factor in each contract separately. The aim is to make profit both in terms of each factor and on a portfolio level, while the previous market condition are changing.
The second kind of risk grow out of the possibility of a default by the counterparty. At the beginning the parties have the same position, the swap initially is worth zero and both parties know that they are exposed to the market risks, and as expected there will be a cash flows exchange on the floating rate side and on the fixed rate one. One party has a credit exposure from a swap only when the value of the swap to it is positive. As this value becomes negative and the counterparty get into financial difficulties, the party could realize a windfall gain, because a default would allow it to get rid of a liability. It may occur that in practice the counterparty would opt to sell the contract to a third party or rearrange its affairs as not to lose positive value in the contract. However a plausible consideration you should come to is as follows: if the counterparty goes bankrupt, there will be a loss if the swap value to the intermediary is positive, otherwise if the swap value to the financial institution is negative there will be no effect on its position.
In conclusion as market risks can be hedged relatively easily by engaging into offsetting contracts, credit risks are less simple to manage.
2.4 Interest rate swap
The most common kind of interest rate swap is called "plain vanilla". In this swap the party, A, agrees to pay the party B cash flows at a predetermined fixed rate on a notional principal for a certain number of years. In return, party A contracts to pay party B a floating rate on the same notional principal for the same period of time. The floating rate in many interest rate swaps is the LIBOR( London Interbank Offer Rate), which is reference interest rate for loans in international financial markets.
We suppose a 2 year swap initiated on April 1 2008, in which company B agrees to pay company A an interest rate of 6 percent per annum on a principal of $100 million, and in return company A contracts to pay company B the six-month LIBOR rate on the same principal. Let's assume that the payments have to be exchanged every 6 months and that the 6 percent interest rate is quoted with semiannual compounding. The first exchange of payments takes place on October 1 2008, six months after the initiation of the agreement. Company B will pay company A $3 million. It is the interest on the $100 million principal for 6 months at 6 percent. As far as company A, interest rate payments are based on the 6 month LIBOR rate prevailing 6 months prior to October 1 2008. We suppose that the 6 month LIBOR rate on April 1 2008 is 5.5 percent . Company A pays B 0.5 x 0.055 x $100 = 2.75 million. The second exchange of payments is on April 1 2009 and company B will pay $3 million to A. Company A will pay interest to B at the six-month LIBOR rate prevailing on October 1 2008. Let's assume that six-month LIBOR rate on October 1 2008 is 4.5 percent, then company A pays B 0.5 x 0.059 x $100 = $2.95 million. The swap entails totally four exchanges of payment: the fixed payments are always $3 million, the floating rate payments depend indeed on the six-month LIBOR rate observed six months prior to the payment date. Interest rate swaps' are set up so that one party remits the difference between the two interest payments to the other party. In this case company B will pay A $0.25 million on October 1 2008 and $0.05 million on April 2009.
Date
Six-month LIBOR rate
Floating cash flow received
Fixed cash flow paid
Net cash flow
April 1,2008
5.5%
October 1, 2008
5.9%
2,75
3
-0,25
April 1,2009
6.2%
2,95
3
-0,05
October 1, 2009
6.5%
3,1
3
0,1
April 1,2010
3,25
3
0,25
The table above illustrates an example of the payments made on the swap for a given set of six month LIBOR rates, showing the swap cash flows from the company's B perspective.
