Derivative markets: swaps

Learning outcomes

After studying this text the learner should / should be able to:

1. Define a swap.

2. Describe the different types of swaps.

3. Elucidate the motivations underlying interest rate swaps.

4. Illustrate how swaps are utilised in risk management.

5. Appreciate the variations on the main themes of swaps.

Introduction

Figure 1 presentó the derivatives and their relationship with the spot markets.

derivatives and relationship with spot markets

Figure 1: derivatives and relationship with spot markets

Swaps emerged internationally in the early eighties, and the market has grown significantly. An attempt was made in the early eighties in some smaller to kick-start the interest rate swap market, but few money market benchmarks were available at that stage to underpin this new market. It was only in the middle nineties that the swap market emerged in some of these smaller countries, and this was made possible by the creation and development of acceptable benchmark money market rates. The latter are critical for the development of the derivative markets.

We cover swaps before options because of the existence of options on swaps. This illustration shows that we find swaps in all the spot financial markets.

A swap may be defined as an agreement between counterparties (usually two but there can be more parties involved in some swaps) to exchange specific periodic cash flows in the future based on specified prices / interest rates. The cash flow calculations are made with reference to an agreed notional amount (i.e. an amount that is not exchanged). Swaps allow financial market participants to better manage risk in their relevant preferred habitat markets.

Swaps are a significant part of the financial markets and, as noted, are found in all the markets. The interest rate swap has a leg in the money market and a leg in the bond market. Equity / share swaps have a leg in the share market and the other in the bond market (and sometimes the money market). Currency swaps (not to be confused with foreign exchange swaps) have two legs in the foreign exchange market, but in different geographic markets. Commodity swaps involve the exchange of a fixed price on a commodity for the spot price (usually an average), and sometimes the transaction does not include the same commodity. The swap market maybe depicted as in Figure 2.

swaps

Figure 2: swaps

To this list may be added the credit risk swap, but as the compensation for the "protection buyer" is contingent upon a "credit event", it is more akin to an insurance policy, and will be discussed in the "other derivatives" section.

The various swaps undertaken in the five markets are covered briefly below. Interest rate swaps dominate and are given pole position, and we conclude with brief sections on the listed swaps in South Africa and the organisation of the swap market. The following are the headings:

• Interest rate swaps.

• Currency swaps.

• Equity / share swaps.

• Commodity swaps.

• Listed swaps.

• Organisation of the swap market.

Interest rate swaps

Introduction

An interest rate swap entails the swapping of differing interest obligations between two parties via a facilitator, usually a bank that focuses on this market (and makes a market in this market). It is an agreement between two parties to exchange a series of fixed rate cash flows for a series of floating rate cash flows in the same currency. These interest amounts are calculated with reference to a mutually agreed notional amount. The notional amount is not exchanged between the parties.

The party that agrees to make fixed interest rate payments is called the buyer and the party that undertakes to make floating rate payments is called the seller. These swaps are also called coupon swaps. When two floating rates are exchanged they are called basis swaps. In fact, there are a variety of interest rate swaps, and these are mentioned at the close of this section. The following sections are covered here:

• Motivation for interest rate swaps.

• Coupon swap: transforming a liability.

• Coupon swap: transforming an asset.

• Coupon swap: comparative advantage.

• Organisation of the swap market.

• Variations on the theme.

 
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