The first swap contract were negotiated in the early 1980's.since then the swaps market had seen a tremendous growth.now swaps occupies a lead role in over the counter (OTC) products.
A derivative can be defined as a financial instrument whose value depends on (or derives from) the value of underlying variable. Underlying variable is defined as a variable on which the price of an option depends. Its Very often the variables underlying derivatives are the prices of assets The nature of derivatives is becoming increasingly complex. Derivatives are being written on not just assets but also on other non-assets like interest rates, weather parameters, credit risk etc. Price of derivative thus can be said to be dependant on any variable ranging from stock price to amount of snow falling in certain area.
According to ISDA swaps can be defined as "a privately negotiated agreement between two parties to exchange cash flows at specified intervals (payment dates) during the agreed-upon life of the contract (maturity or tenor)". A swap is a agreement between two parties to exchange cash flows in the future. The agreement defines the date when the cash flows had to be exchanged and how the cash flow is to calculated.
Over last 30 years derivatives have become increasingly important and predominant instruments in finance. Historically derivatives are being used to hedge against a risk by hedgers and to speculate over price movements by speculators. Widest use of derivatives was initially to hedge or to speculate on the market risk. In the 90s need to protect lenders against credit risk was also identified, due to increased complexity in the financial world, increasing amount of leverage in the system and resulting defaults by borrowers. Thus wide use of credit derivatives started to take place in order to hedge against the credit risk. This was done to introduce a popular product called 'Credit Derivative Products'.
Over last decade there has been tremendous growth in the use of credit derivatives. As per ISDA (International Swaps and Derivatives Association), total notional principal for outstanding credit derivative contracts was about $42 trillion i.e. almost 80 percent of the world GDP. Total notional in 2000 was just $800 billion. This shows the level of growth witnessed over last decade. Post financial crisis of 2008-2009, total notional has reduced to $ 31.22 trillion in 1st half of 2009, as per ISDA on account of continued efforts at portfolio compression at major dealers. But, with economic activity picking up, it is expected that within next 2 years the notional will rebound.
Historically banks and other financial institutions used to be in the position where they could do little once they assumed credit risk except to wait till the entire obligation is met by the borrower and serviced adequately.
Types of swaps :
The 5 generic types of swaps are as follows in order of their quantitative importance :
Interest rate swaps
Currency swaps
Credit swaps
Commodity swaps
Equity swaps
Most swaps are traded over-the-counter (OTC), "tailor-made" for the counterparties. Some types of swaps are also exchanged on futures marketsi.e they are not the OTC contracts such as the Chicago Mercantile Exchange Holdings Inc., the largest U.S. futures market, the Chicago Board Options Exchange, Inter continental Exchange and Frankfurt-based Eurex AG etc.
The credit exposure of a swap can be defined as the amount that would be lost if default were to occur immediately at the same time. Credit exposure is equal to the current market value if positive and the credit exposure will be zero if current market value is negative. Swap participants also deduce future exposures of swaps, which are potential positive values during the life of the swap; future exposures are used to establish credit charges which is expected exposure and credit limit usage which is called as peak exposure.
Interest rate swaps :
According to ISDA "An interest rate swap can be defined as agreement to exchange interest rate cash flows, calculated on a notional principal amount, at specified intervals known as payment dates during the life of the agreement. Each party's payment obligation is usually computed using a different interest rate. In an interest rate swap, the notional principal is never exchanged,only there is a exchange of interest rate. Although there are no standardized swaps, a plain vanilla swap refers to a generic interest rate swap in which one party pays a fixed rate and one party pays a floating rate which is usually LIBOR.
The valuation of a interest rate swap can be deducted from net difference between the present value of the payments the counterparty expects to receive during the tenure of agreement and the present value of the payoff's the counterparty expect to make during the tenure of the agreement. At the inception of the swap, the value is generally zero to both parties and becomes positive to one and negative to the other depending on the movement of interest rates in both directions whether upwards or downloads. Present value is the value of a cashflows to be received in the future, adjusted for the time value of money (interest foregone while waiting for the quantity) by taking the appropriate discounted factor. Typically, a party entering a swap gives up or takes on exposure to a given interest rate. At the same time, each party take on the risk known as counterparty credit risk that the other party will default at some time during the tenure of the contract.
Loss on a swap can occur both in the following two instances First, the counterparty had to default and secondly the swap must have a positive value to the party that does not default. The amount of the loss depends on the credit exposure of the swap during the tenure of agreement.
Interest rate swap "Buyer" and "Seller"
payer of fixed rate is "buyer".
Fixed rate payer "buys" floating rate (LIBOR),
the fixed rate is the "price"
suppose 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.
Market makers :
Many large financial institutions acts as a market makers for swaps.this means that they are ready to enter into a swap agreement without entering into a counterswap with some other party.market makers have to carefully hedge and quantify the risk they are taking by entering into a swap.
Currency swaps :
It involves exchanging fixed rate interest payment and principle on a loan in one currency for fixed interst payment and principle on a equal and same type of loan in some different currency.currency swaps also have comparative advantage similar to interest swaps.
Currency swaps are over-the-counter derivatives, and are closely related to interest rate swaps. However they are different from interest rate swaps in the sense that , currency swaps can involve the exchange of the principal.
There are three different ways in which currency swaps can exchange loans:
The first primary structure can be with the counterparty, at a rate agreed now, at some specified point in the future. Such an agreement performs a contract equivalent to a forward contract or futures. The cost of finding a counterparty which may be either directly or through an intermediary, and drawing up an agreement with them, makes swaps more expensive than alternative derivatives as there is a cost involved (and thus rarely used) as a method to fix shorter term forward exchange rates. However for the longer term future, commonly up to 10 years, where spreads are wider for alternative derivatives, principal-only currency swaps are often used as a cost-effective way to fix forward rates. This type of currency swap is also known as an FX-swap.
Another currency swap structure is to combine the exchange of loan principal, as above, with an interest rate swap. In such a swap, interest cash flows are not netted before they are paid to the counterparty same as vanilla interest rate swaps because they are denominated in different currencies. As each party effectively borrows on the other's behalf, this type of swap can be termed as back to back loan.
Last but not the least is to swap only interest payment cash flows on loans of the same size and tenure. Again, as this is a currency swap, the exchanged cash flows streams are in different denominations and they cant be netted. An example of such a swap is the exchange of fixed-rate US Dollar interest payments for floating-rate interest payments in Euro. This type of swap is also known as a cross-currency interest rate swap.
Currency swaps can be said to have 2 major advantages:
To have cheaper debt by borrowing at the best available rate regardless of currency and then swapping for debt in desired currency using a back-to-back-loan.
To hedge against exchange rate fluctuations
Credit swaps :
Over last decade there has been tremendous growth in the use of credit derivatives. As per ISDA (International Swaps and Derivatives Association), total notional principal for outstanding credit derivative contracts was about $42 trillion i.e. almost 80 percent of the world GDP. Total notional in 2000 was just $800 billion. This shows the level of growth witnessed over last decade. Post financial crisis of 2008-2009, total notional has reduced to $ 31.22 trillion in 1st half of 2009, as per ISDA on account of continued efforts at portfolio compression at major dealers. But, with economic activity picking up, it is expected that within next 2 years the notional will rebound.
Historically banks and other financial institutions used to be in the position where they could do little once they assumed credit risk except to wait till the entire obligation is met by the borrower and serviced adequately.
Now due to credit derivative products, they can actively manage credit risk, keeping some credit exposures and entering into credit derivative to protect from risky exposures. In dealing with credit derivatives, banks have been major buyers of credit derivatives, where as underwriters or sellers for credit derivatives have been insurance companies and certain hedge funds.
Credit derivatives can be 'single name' or 'multi name' depending upon whether company which is reference for the credit event to occur is single company or a portfolio of exposure to various companies. One of the most important credit derivative instrument in the world market is single name credit default swap popularly knows as CDS. Till last two years other forms of CDS, such as multi name CDS, basket CDS, Credit Linked Notes, etc. were gaining wide acceptance. But, post credit crisis of 2008 and increased risk aversion, there has been reduction in use of advanced credit derivative products which are based on complex valuation models. Thus, it may be some time before multi name structured credit products will gain popularity. Single name CDS are widely used globally as they follow a comparatively simpler valuation model and are less opaque in terms of transparency of the transactions involved.
Credit default swap (CDS) is a contract that provides insurance against risk of default by a particular company. The company in the event is knows as reference entity and default by the company is called as credit event. The buyer if the insurance obtains the right to sell bond issued by company for their face value when a credit event occurs and the seller agrees to buy the bonds for their face value when credit event occurs. Total face value of the bonds that can be sold is known as credit default swap's notional principal. The buyer of CDS makes periodic payments to the seller until the end of the life of CDS or until a credit event occurs. These payments are typically made in arrears every quarter, every half year, or every year. The settlement in the event of a default involves either physical delivery of the bonds or a cash payment.
An example shown below illustrates how a CDS deal is structured. Consider two parties that have entered into a 5-year credit default swap on March 1, 2009. Assume that the notional principal is Rs. 100 million and the buyer agrees to pay 90 basis points annually for protection against default by the reference entity. Typical transaction taking place between the two parties has been shown in the figure below.
90 basis points per year
Payment if default by reference entity
re
Default Default
Protection Protection
Buyer Seller
Figure 1 Credit Default Swap
If the reference entity does not default then the buyer receives no payoff and pays Rs. 900,000 on March 1 of each year for 2010 to 2014. In case of a credit event, substantial payoff to buyer is likely. Suppose a credit event occurs, and buyer notifies the seller about credit event on say June 1, 2012, then there is a payoff to the buyer, depending on the type of the settlement.
If the contract specifies physical settlement, then the buyer has the right to sell bonds issues by the reference entity with a face value of Rs. 100 million for Rs. 100 million. In case of cash settlement, an independent valuation provider polls dealers to determine mid-market value of the cheapest deliverable bond within predetermined number of days after the credit event. Suppose, the bond is valued as worth Rs. 40 per face value of Rs. 100, then the cash payoff to the buyer is Rs. 60 million. Although, the payment made by buyer to seller to buy protection per year (also known as CDS spread) is paid quarterly, half-yearly or annually, payment from buyer to seller in arrears in required, even when a credit event occurs. It is better for buyer to opt for physical settlement, if has the skills to handle the recovery process and has the expertise in it. Hedge funds that specialize in distress asset funds often would opt for physical settlement, where as firms like insurance companies will tend to opt for cash settlement.
Over last decade there has been tremendous growth in the use of credit derivatives. As per ISDA (International Swaps and Derivatives Association), total notional principal for outstanding credit derivative contracts was about $42 trillion i.e. almost 80 percent of the world GDP. Total notional in 2000 was just $800 billion. This shows the level of growth witnessed over last decade. Post financial crisis of 2008-2009, total notional has reduced to $ 31.22 trillion in 1st half of 2009, as per ISDA on account of continued efforts at portfolio compression at major dealers. But, with economic activity picking up, it is expected that within next 2 years the notional will rebound.
Historically banks and other financial institutions used to be in the position where they could do little once they assumed credit risk except to wait till the entire obligation is met by the borrower and serviced adequately.
Now due to credit derivative products, they can actively manage credit risk, keeping some credit exposures and entering into credit derivative to protect from risky exposures. In dealing with credit derivatives, banks have been major buyers of credit derivatives, where as underwriters or sellers for credit derivatives have been insurance companies and certain hedge funds.
Credit derivatives can be 'single name' or 'multi name' depending upon whether company which is reference for the credit event to occur is single company or a portfolio of exposure to various companies. One of the most important credit derivative instrument in the world market is single name credit default swap popularly knows as CDS. Till last two years other forms of CDS, such as multi name CDS, basket CDS, Credit Linked Notes, etc. were gaining wide acceptance. But, post credit crisis of 2008 and increased risk aversion, there has been reduction in use of advanced credit derivative products which are based on complex valuation models. Thus, it may be some time before multi name structured credit products will gain popularity. Single name CDS are widely used globally as they follow a comparatively simpler valuation model and are less opaque in terms of transparency of the transactions involved.
Credit default swap (CDS) is a contract that provides insurance against risk of default by a particular company. The company in the event is knows as reference entity and default by the company is called as credit event. The buyer if the insurance obtains the right to sell bond issued by company for their face value when a credit event occurs and the seller agrees to buy the bonds for their face value when credit event occurs. Total face value of the bonds that can be sold is known as credit default swap's notional principal. The buyer of CDS makes periodic payments to the seller until the end of the life of CDS or until a credit event occurs. These payments are typically made in arrears every quarter, every half year, or every year. The settlement in the event of a default involves either physical delivery of the bonds or a cash payment.
An example shown below illustrates how a CDS deal is structured. Consider two parties that have entered into a 5-year credit default swap on March 1, 2009. Assume that the notional principal is Rs. 100 million and the buyer agrees to pay 90 basis points annually for protection against default by the reference entity. Typical transaction taking place between the two parties has been shown in the figure below.
90 basis points per year
Payment if default by reference entity
re
Default Default
Protection Protection
Buyer Seller
Figure 1 Credit Default Swap
If the reference entity does not default then the buyer receives no payoff and pays Rs. 900,000 on March 1 of each year for 2010 to 2014. In case of a credit event, substantial payoff to buyer is likely. Suppose a credit event occurs, and buyer notifies the seller about credit event on say June 1, 2012, then there is a payoff to the buyer, depending on the type of the settlement.
If the contract specifies physical settlement, then the buyer has the right to sell bonds issues by the reference entity with a face value of Rs. 100 million for Rs. 100 million. In case of cash settlement, an independent valuation provider polls dealers to determine mid-market value of the cheapest deliverable bond within predetermined number of days after the credit event. Suppose, the bond is valued as worth Rs. 40 per face value of Rs. 100, then the cash payoff to the buyer is Rs. 60 million. Although, the payment made by buyer to seller to buy protection per year (also known as CDS spread) is paid quarterly, half-yearly or annually, payment from buyer to seller in arrears in required, even when a credit event occurs. It is better for buyer to opt for physical settlement, if has the skills to handle the recovery process and has the expertise in it. Hedge funds that specialize in distress asset funds often would opt for physical settlement, where as firms like insurance companies will tend to opt for cash settlement.
Commodity swaps :
A swap in which exchanged cash flows between two parties are dependent on the price of an underlying commodity. This is a swap where payments are based on the prices of commodities. One party pays a fixed price for the good over life of the swap while the other pays a floating price for the good, depending on current market prices.
Commodity swaps involve two parties which are known as counterparties. Swaps are done through a agreement in which cash flows deduce its value upon the price of a given commodity. On settlement dates which are pre decided or dates on which the commodity price is recorded, cash-flow exchanges between the parties takes place. The type of commodity swap entered between two parties depends on investment tactics specifically whether a party is and end point user such as aspecific producer or consumer of the commodity, or a speculator attempting to make money from price fluctuations.
In addition to the underlying intent, commodity swaps are usually designed to fit to individual party financial need.Swaps may be arranged as fixed floating agreements, for example. In such a contract, one of the party will pay the fixed cash flows while the other will pay the floating on the settlement date. The price which is agreed by both the parties is determined by an exchange, such as the Commodities Research Board Index. A fixed floating can be termed as sometime as simple swaps.
By contrast, a swap can be put a cap on prices to be paid for commodities In these cases, a acap or floor price is fixed, meaning that one party upfront specified amount, while the counterparty pays the difference by which the price rise or falls below the contract price on the settlement date.For example: In a commodity swap, a party may agree to exchange cash flows linked to prices of oil for a fixed cash flow.
Commodity swaps are used for hedging against risk in Fluctuations in commodity prices or even between final product and raw material prices For example: Cracking spread which indicates the spread between crude prices and refined product prices significantlyaffect the profitability of oil refiniries.
A company that uses commodities as input may find its marging becoming very volatile if the commodity prices or the raw materials becomes volatile.
This is particularly so when the output prices can not be raised as the commodity prices becomes volatile. In such cases, the company would enter into a swap whereby it receives payment linked to commodity prices and in turn it pays fixed payments.
For example, consider a commodity swap which involves notional principal of 50,00,000 barrels of crude oil. One party agrees to make fixed semi-annual payments at a fixed price of Rs 2,500/bbl, and in turn receiving floating payments or cash flows.
On the first settlement date, if the spot price of crude oil is Rs 2,500/bbl, the pay-fixed party must pay (Rs 2,400/bbl)*(50, 00,000 bbl) = Rs 12,00,000,000.
The pay-fixed party also receives (Rs 2,500/bbl)*(50, 00,000 bbl) =Rs 12,50,000,000.
The net payment made (cash out flow for the pay-fixed party) is then Rs 50,000,000.
In a different scenario, if the price per barrel will have increased to Rs 2,550/bbl than the pay-fixed party would have received a net inflow of Rs 50,000,000.
By contrast, a swap can be structured to limit the price paid for the commodity. In these cases, a limit i.e a cap or floor price is placed, meaning that one party pays a specified amount up front, while the counterparty pays the difference by which the price exceeds or falls below the contract price as of the settlement date.
Equity swaps :
An Equity Swap is a contractual agreement between two counterparties fir a fixed tenure to exchange cash flows arising from specific assets. The cash flows are exchanged periodicallyi.e monthly, quarterly ,yearly and are based upon the fixed-dollar or notional value of the swap. The notional principal of the swap is not directly exchanged but is used to calculate the periodic payments of the parties In most instances, holders of concentrated equity positions would agree to pay say The Bank of americathe total return which is the positive movement and dividends received on the stock over a fixed period based upon the notional principle of the equity swap. In exchange, the other party or investor will receive payments on some another asset such as a an equity index, fixed or floating money market rate or a securities basket of securities including i.e addition of subtraction of spreads. If the return on the stock is negative, the investor will also receive the difference from The Bank of America . Similarly, if the return is negative, the investor will pay the difference to The Bank of america
Example
The investor is unable to sell the shares due to holding period restrictions or volume limitations. An investor owns 100,000 shares of XYZ stock with a current market price of $75.00. The investor enters into a two-year, cash-settled, equity swap with The Bank of Aamerica as he seeks to eliminate economic exposure to XYZ stock and diversify into another asset.whereby the investor agrees to pay at maturity the total performance of XYZ stock and receives payments which is quarterly the total performance of three-month LIBOR minus a spread. The notional value of the equity swap is $7,500,000. Each quarter, The Bank of america will pay the three-month LIBOR rate minus a spread, divided by quarter i.e 4, multiplied by $7,500,000 to the investor. At maturity, the investor will pay to The Bank of america the total positive price performance of XYZ stock multiplied by $7,500,000. Dividends will be paid to The Bank of america when the investor receives them.
Typical Characteristics:
Start date:
Spot or forward
Term:
Up to 10 years
Payment Frequency:
Annually, Semi-Annually, Quarterly, or Monthly
Day Count:
30/360, Actual/360, or Actual/365
Structure:
Bullet, Amortizing, or Accreting
Floating Rate Index:
LIBOR, Prime, Commercial Paper, or S&P 500
Equity Swap Diagram:
