The Ultimate Guide To The Swap Market
Exchange rate instability and the collapse of the Bretton Woods System and particularly the control over the movement of the capital internationally paved the way for the origin of the financial swaps market. Today swaps are at the center of the global financial revolution. The growth is such that sometimes it looks unbelievable but it is true. Though its growth will continue or not is doubtful.
Swap is an agreement between two or more parties to exchange sets of cash flows over a period in the future. The parties that agree to swap are known as counterparties. It is a combination of purchases with a simultaneous sale for the equal amount but different dates. Swaps are used by corporate houses and banks as an innovating financing instrument that decreases borrowing costs and increases control over other financial instruments. It is an agreement to exchange payments of two different kinds in the future. A financial swap is a funding technique that permits a borrower to access one market and then exchange the liability for another type of liability. The first swap contract was negotiated in 1981 between Deutsche Bank and an undisclosed counterparty. The International Swap Dealers Association (ISDA) was formed in 1984 to speed up the growth in the swap market by standardizing swap documentation. In 1985, ISDA published the standardized swap code.
Features of swap
Swaps are contracts of exchanging the cash flows and are tailored to the needs of counterparties. Swaps can meet the specific needs of customers.
Counterparties can select amount, currencies, maturity dates etc.
Exchange trading involves lass of some privacy but in the swap market privacy exists and only the counterparties know the transactions.
There is no regulation in the swap market.
There are some limitations like
(a) Each party must find a counterparty which wishes to take the opposite position.
(b) Determination requires to be accepted by both parties.
(c) Since swaps are bilateral agreements the problem of potential default exists.
There are two kinds of the swap, they are as follows:
1. Currency swap: It is an agreement whereby currencies are exchanged at specified exchange rates and at specific intervals. The reason is to lock in the exchange rate. Large commercial banks that sen,’e as an
intermediary agree to swap currencies with a firm. Two currencies are already the shaking has started. In the ―plain vanilla‖ dollar sector, the profits for brokers and market makers, after costs and allocation of risk capital, are measured in fewer than five basis points. This is before the regulators catch up and force disclosure and capital haircuts. At these spreads, the more highly paid must move on to currency swaps, tax-driven deals, tailored structures, and schlock swaps.
The fact which is certain is that, although the excitement may diminish, swaps will stay. Already, swaps have had a major macroeconomic impact forging the linkage between the euro and the domestic markets, flattening the cash yield curves, and reducing central bank monopoly influence on markets. We are all swappers now. And remember the saying ―beware of honey offered on a sharp knife‖ when you are offered sweet deals. The problem in following the chaotic process of this very important market is quite simply that ―he who knows does not speak, he who speaks does not know.‖ A glimpse of the growth of the swap market and a shortlist of the non-proprietary tools in the swapper‘s arsenal is given below:
The concept of the SWAPS: The aim of the swap contract is to bind the two counterparties to exchange two different payment streams over time, the payment being tied, or at least in part, to subsequent—and uncertain—market price developments. In most swaps so far, the prices concerned have been exchanged rates or interest rates, but they increasingly reach out to equity indices and physical commodities. All such prices have risk characteristics in common, in quality if not degree. And for all, the allure of swaps may be expected cost saving., yield enhancement, or hedging or speculative opportunity.
Portfolio management requires financial swaps which are simple in principle, versatile in practice yet revolutionary. A swap coupled with an existing asset or liability can radically modify effective risk and return. Individually and together with futures, options and other financial derivatives, they allow yield curve and currency risks, and liquidity and geographic market considerations, all to be managed separately and also independently of underlying cash market stocks.
Growth of the SWAP Market: In the international finance market most of the new products are executed in a physical market but swap transactions are not. Participants in the swap market are many and varied in their location character and motivate in exciting swaps. However, in general, the activity of the participants in the swap market has taken on the character of a classical financial market connected to, and integrating the underlying money, capital and foreign exchange market.
Swap in their current form started in 1981 with the well-publicized currency swaps, and in the following year with dollar interest rate swaps. The initial deals were characterized by three critical features.
- Barter- two counterparties with exactly offsetting exposures were introduced by a third party. If the credit risk were unequal, the third party- if a bank – might interpose itself or arrange for a bank to do so for a small
- Arbitrage is driven- the swap was driven by an arbitrage that gave some profit to all three parties. Generally, this was a credit arbitrage or market- access
- Liability driven- almost all swaps were driven by the need to manage a debt issue on both The major dramatic change has been the emergence of the large banks as aggressive market makers in dollar interest rate swaps. Major US banks are in the business of taking credit risk and interest rate risk. They, therefore, do not need counterparties to do dollar swaps. The net result is that spreads have collapsed and volume has exploded. This means that institutional investors get a better return on their investments and international borrowers pay lower financing costs. This, in turn, results in more competitively priced goods for consumers and in enhanced returns pensioners. Swap, therefore, have an effect on almost all of us yet they remain an arcane derivative risk management tool, sometimes suspected of providing the international banking system with tools required to bring about destruction.
Although the swap market is now firmly established, there remains a wide divergence among current and potential users as to how exactly a given swap structure works, what risks are entailed when entering into swap transactions and precisely what ―the swap market‖ is and, for that matter is not.
The basic SWAP Structures: The growth and continued success of the swap market have been due to a small part of the creativity of its participants. As a result, the swaps structures currently available and the future potential structures which will in time become just another market ―normal are limited only by the imagination and ingenuity of those participating in the market. Nonetheless, underlying the swap transactions seen in the market today are four basic structures which may now be considered as fundamental.
These structures are:
- the Interest Rate Swap
- the Fixed Rate Currency Swap
- the Currency Coupon Swap
- the Basis Rate Swap
The Currency SWAP Market: Main Features The oldest and the most creative sector: The currency swap market is the oldest and most creative sector of the swap market. This is not distinguished in market terms between the fixed-rate currency swap and the currency coupon swap. There is no distinction in market terms between these two types of currency swaps because the only difference is whether the counter currency receipt/payment is on a fixed or floating basis- in structure and result, the two types of swaps are identical and it is a matter of taste (or preference) for one or both counterparties to choose a fixed or floating payment. When the dollar is involved on one side of a given transaction, the possibility to convert a fixed-rate preference on one side to a floating rate preference on the other side through the interest rate swap market makes any distinction even more irrelevant. However, for those who like fine distinctions, there is a tendency in the market to regard the fixed-rate currency swap market as more akin to the long date forward foreign exchange market (because when one is executing a fixed currency swap one may often be competing with the long-dated FX market) and the currency coupon swap market as more akin to the dollar bond/ swap market (because the dollar bond issuer compares the below LIBOR spread available in the dollar market to that available, say, through tapping the Swiss Franc market.)
Most Interesting Sector of the Swap Market: Whatever distinctions one wishes to draw or not to draw between the two basic types of swaps in the currency swap market, there are many reasons why this market is the most creative and therefore, most interesting sector of the swap market. While still smaller than the dollar interest swap market, the currency swap market has great and perhaps even greater potential for growth than the dollar market, particularly in the light of the growth in local/ Euro capital markets in a wide range of currencies.
The Primary and the Secondary Sector: One can classify activity in the currency swap market into the same two basic sectors as the interest swap market – a primary and secondary sector. In the currency swap market, the primary sector is dominant across the yield curve and the key motivating forces underlying this market are ―new money and ―hedging in that order. ―New money or the willingness to execute swap-related public or private financing in one currency to achieve a finer cost or enhanced availability in another currency is the key motivating force behind the currency swap market, particularly for banks and sovereign entities. Such entities have had large capital and refinancing requirements in recent years. The capacity of any one market (eg: the Eurodollar bond market) to provide all of these requirements at the finest possible cost has been limited. Hence, many banks and sovereigns have been willing to approach the private and public debt markets in currencies for which they have no natural requirements (but which the swap market can use) in order to reduce costs and/or gain greater access to a particular currency which is required. Restructuring, or ―hedging‖ current debt portfolios, cash flows or investments, is clearly an influence of second-order is comparisons to the influence of ―new money‖. The flexibility of loan repayment clauses and the fact that many corporate and sovereign entities have found their access to a wide range of securities markets greatly expanded in recent years means that even if the fundamental motivation of a currency swap is restructuring/ hedging, this would normally be preceded by an issuer first obtaining a cheaper cost of funds in the base currency through securities or near security transactions.
Creativity: From the market point of view, the driving force of the currency swap market is creativity. Structures in the currency swap market range from the extremely simple to the complex, multi-faceted, multi-counterpart transactions whose economies exist in the dimensions available only to the mathematician. One is limited in the currency swap market only by the problem to be solved, one‘s imagination, the skills of your personal computer operators and of course, the ability of your colleagues to find suitable counterparts around the world at the right time and price. As opposed to the dollar market, where capital commitment has become increasingly important, the key in the currency capital commitment has become increasingly important, the key in the currency swap market is still a commitment to creative problem-solving and development of a swap distribution system on a global basis—classic investment banking.
Individual Demand and Supply Interplay: Warehousing in the primary market is not widespread due to the difficulty of covering the interest rate risks while the swap is in position. A swap arranger can cover the foreign exchange risks associated with ―booking open‖ a position in a given currency but often times the arranger cannot cover against a movement in interest rates for that currency or is forced to use (generally poor) surrogate cover. This is due to the fact that currency swap rates generally move to the laws of their own supply and demand and do not necessarily relate to say, local government bond markets where cover in some currencies can be obtained (particularly sterling and Deutschmarks). But the taking of position does not take place among a few selected players and such market-making is not done on a much wider spread basis versus capital market rates than in the dollar interest swap market. However, until the better and more consistent relationship between swap rates and the available interest cover develops, position-taking in the currency swap market will remain very much akin to long-dated forward foreign exchange dealing and less toward the classic arbitrage model of the swap market.
The Most Important Currencies of the Swap Market: The most important currencies in the swap market in rough order of magnitude are the Swiss Franc, Yen, Deutschmarks, Pound sterling and Canadian dollar. These currencies are popular in the swap market due to their low-interest rates (versus Dollar) and the relative ease of access by a wide range of issuers to private and public debt in the ―Euro‖ and domestic markets of these currencies. Many supranational and sovereign borrowers find their access to the debt markets of such currencies constrained (versus their sometimes quite large requirements) and therefore make extremely active and frequent use of the currency swap market. Such entities either lend in their currencies (and are therefore covering/ matching assets with liabilities) or are trying to diversify their debt portfolios away from the dollar and the costs of the vagaries of that currency can impose on national budgets.
Dollar’s Domination: Even after so much development in the swap market, the domination of the dollar continues. Though this is also the fact that much direct currency combination continues such as Yen/Swiss Franc. The other high-interest-rate currencies involved in the currency swap market are viewed as speculative vehicles for aggressive debt portfolio managers or companies in the local market which would have to pay dearly for fixed-rate debt. This latecomer accounts for the active use of exotic currency debt markets by prestigious international issuers. This has occurred recently in a number of capital markets in which the first few Euro issues are completed at a wide divergence to the domestic market rates. Thus, the swaps which become available in this way, have accounted for the presence of many high –powered issues. The quality image gained by such issues, should on these markets has gained acceptance for new market and hence, fostered their growth.
In sum, the primary sector of the currency swap market is dominated by new money considerations by issuers and on the other side, by greater access to a select few low interest-rate debt markets by often the same type of entities. There is, however, a greater diversity by type of participants in the currency swap market than the interest swap market with financial institutions, particularly banks, playing a smaller role in the currency market and sovereigns, supranational and corporate playing a relatively larger role than such entities do in the dollar swap market. Position-taking (capital commitment) is still less important than commitment to creativity and distribution capacity among arrangers. While the currency swap market is highly competitive, there is still the possibility to beat your competitor by being smarter, quicker and developing ―niches‖ of special expertise in a particular currency.
Highly Opportunistic Sub-sector: The secondary market is a highly opportunistic sub-sector of the currency swap market and, judging by Bankers Trust‘s own activities in this market, the secondary market in currency swaps is relatively larger in comparison to the primary market. Some of the experts are of the view that this is due to a given swap counterparty having two chances to win on interest and exchange rates- in a currency swap and that with the enormous volatility of the dollar, a chance to win big on an exchange rate play. Although the original motivation may be to create a currency swap but the primary motive in the secondary market is to take profit before a currency move places the swap into an unprofitable position.
New Breed of Financial Management: The secondary market phenomenon is an inherent part of the new breed of financial management which aggressively manages their cash flows and debt portfolios because they are judged by profits. The spreads tend to be relatively wider in the secondary currency than the secondary interest swap markets, move quickly when an exchange rate breaks are the key to the level of profitability. The exchange rate effects the profitability of a swap reversal is so much that the case of the exchange rate that excellent prices and highly attractive rates can be obtained in the secondary market. The reverser needs to move quickly to capitalize on his exchange rate gain. This may lead to the virtual wholesale shutdowns of the primary market in currency swaps. This is so because of the fact that many counterparties want to reverse at the same time. Consequently, this will lead to substantial discounts in interest rates on the secondary market versus the primary market.
Position-taking and Market-making: Unlike in the primary market, the position-taking and market-making are very common in the secondary market due to the excellent pricing available in the secondary market, most of the times. Like the dollar market, sophisticated financial managers are aware that the credit risks are greater in currency swaps. When the time comes to reverse a position these sophisticated financial managers will make a market on the original transactions.
The fixed-rate Currency Swap: A fixed-rate currency swap consists of the exchange between two counterparties of fixed-rate interest in one currency in return for a fixed-rate interest in another currency.
Following are the main steps to all currency swaps:
- Initial Exchange for the Principal: The counterparties exchange the principal amounts on the commencement of the swap at an agreed rate of exchange. Although this rate is usually based on the spot exchange rate, a forward rate set in advance of the swap commencement date can also be used. This initial exchange may be on a notional basis of alternatively a physical exchange. The sole importance of the initial exchange on being either on physical or notional basis, is to establish the quantum of the respective principal amounts for the purpose of –(i) calculating the ongoing payments of interest and (ii) the re-exchange of principal amounts under the swap.
2. Ongoing Exchanges of Interest: Once the principal amounts are established, the counterparties exchange interest payments based on the outstanding principal amounts at the respective fixed interest rates agreed at the outset of the transaction.
3. Re-exchange of the Principal Amounts: On the maturity date the counterparties re-exchange the principal amounts established at the outset. This straight forward, three-step process is standard practice in the swap market and results in the effective transformation of a debt raised in one currency into a fully-hedged fixed-rate liability in another currency.
In principle, the fixed currency swap structure is similar to the conventional long –date forward foreign exchange contract. However, the counterparty nature of the swap market results in far greater flexibility in respect of both maturity periods and the size of the transactions which may be arranged. A currency swap structure also allows for interest rate differentials between the two currencies via periodic payments rather than the lump sum reflected by forwarding points used in the foreign exchange market. This enables the swap structure to be customized to fit the counterparties’ exact requirements at attractive rates. For example, the cash flows of an underlying bond issue may be matched exactly and invariably.
The Currency Coupon SWAP: The currency coupon swap is a combination of the interest rate swap and the fixed-rate currency swap. The transaction follows the three basic steps described for the fixed-rate currency swap with the exception that fixed-rate interest in one currency is exchanged for a floating-rate interest in another currency. By using the currency coupon swap the benefit which can be obtained can be explained with the following example. Suppose an Indian corporate wished to enter a major leasing contract for a capital project to be sited in Japan. The corporate wanted to obtain the advantage of funding through a Japan‘s lease which provided lower lease rentals due to the Japan tax advantages available to the Japan lessor. However, the Corporate was concerned by both the currency and interest rate exposure which would result from the yen based leasing contract. The structure provided by Hankers Trust enabled the Corporate to obtain the cost benefits available from the Japan lease and at the same time convert the underlying lease finance into a fully – hedged fixed-rate yen liability. Under the structure Bankers Trust paid, on a quarterly basis, the exact payments due on the Corporate‘s yen based Japan lease in return for the Corporate paying an annual amount of fixed Japanese Yen to Banker‘s Trust. The amount for fixed Japanese Yen payable reflected the beneficial level of the Japanese Yen lease payments.
The Basis Rates: A fast developing area in the international swap markets is the basis rate swap. The structure of the basis rate swap is the same as the straight interest rate swap, with the exception that floating interest calculated on one basis is exchanged for floating interest calculated on a different basis. The forerunner of this type of swap was the US Dollar Prime Rate LIBOR swap. However, an even larger market has developed for the exchange of I month US Dollar LIBOR for 6 month US Dollar LIBOR and more recently US Dollar LIBOR for US Dollar commercial paper at much finer rates than those available on the foreign exchange market.
The availability of the basis rate swap market provides an excellent method for entities to arbitrage spreads between different floating-rate funding sources. More importantly, it provides a discreet and most efficient method for European entities, in particular, to stimulate the US Commercial Paper funding market without the necessity of meeting the stringent US requirements for a Commercial Paper program. To illustrate, consider a transaction structured by Bankers Trust which enabled a European bank to obtain effective 30-day commercial paper funding by converting its 6 month US Dollar funding base into 30-day commercial paper via a basis rate swap. The counterparty to the transaction was a second European bank wishing to match its commercial paper funding program to its LIBOR asset base.
SWAP Risk and Exposure: The great bulk of swap activity of date has concentrated on currencies and interest rates, yet these do not exhaust the swap concept‘s applicability. As one moves out of the yield curve, the primary interest rate swap market becomes dominated by securities transactions and in particular the Eurodollar bond market. The advent of the swap market has meant that the Eurodollar bond market now never closes due to interest rate levels: issuers who would not come to market because of high-interest rates now do so to the extent that a swap is available. Indeed, the Eurodollar bond market owes much of its spectacular growth to the parallel growth of its swap market. The firms that now dominate lead management roles in the Eurodollar bond market all have substantial swap capabilities and this trend will continue. One extension is seen at the beginning of the market for equity swaps- an exchange of coupons on some bonds for dividends on some equities, or an index instrument thereof (capital appreciation also may be included on one or both sides of the swap). The purpose is to earn equity returns when the investor deems them promising but without the transaction costs of liquidating an existing bond position or building an outright equities position, while also providing the complication of the unfamiliar local market and the time and trouble of stock-picking if the index will suffice. Equity swaps (and, indeed, all swaps) further may be enhanced by options features customized to the interests of the creditworthy, sophisticated investor Commodities are another fertile area for swaps in view of the limited scope of price protection alternatives. There is modestly growing swap activity in the principal non-ferrous metals, such as copper and aluminum, and rather more in gold, based partly on the advantages of the swap investment for protecting long –term project financing vulnerable to price instability. The major focus, however, now lies in petroleum and petroleum products. This is the physical commodity sector most critical to find economic uses. Since the mid-1980s, this sector has become one of the most heavily traded in the cash and futures market worldwide.
Essentials for reducing Swap risks: There are certain precautions that are suggested to be taken to reduce the swap risk. They are as follows:
1. Undertaking more stringent credit analyses and use greater care in selecting counterparties: This provides the best insurance against the swap risk. Having a financially strong counterparty not only minimizes the chances of default hut also facilitates the transfer of a swap, for either profit or lack of need, or both.
2. Master agreements: These stipulate all swaps between two parties are cross-defaulted to each other, default on anyone swap triggers suspension payments on all others covered in the agreement. Such arrangements normally pre-suppose frequent transactions between the parties. They also are most effective in reducing exposure when a balance exists in swap positions between paying and receiving fixed rate flows, and between notional principal amounts and maturities.
3. Collateralization: Collateralization with marketable securities has become an essential feature of swaps with dubious credits. The right to call can be mutual which normally applies only in one direction, depending on the relative strength of the two parties.
4. Better documentation: More protective documentation in swap agreements can provide trigger points for remedial action in advance of actual default. Users could require, for example, that the various tests of financial condition found in credit agreements can provide trigger points for remedial action in advance of actual default. Users could require, for example, that the various tests of financial conditions found in credit agreement are incorporated into swaps contracts.
5. Net settlements: To minimize risk, a swap user is will be advised to insist on the settlement of all payments on the same day and on a net basis. A payment lag can leave a user vulnerable to loss of its counterparty defaults before the corresponding payment has been made.