Swaps

  Table of Contents S.No.Page#1.Introduction12.Swaps13.Swap Market24.Types3i.Interest rate swap4ii.Currency swap6iii.Commodity swap7iv.Equity swap7v.Credit default swap8vi.Other variations85.Valuation96.Currency swap V/S Interest rate swap11  Introduction The implacable wave of credit crisis casualties has financial institutions scrambling to protect their bottom line. In these uncertain times, once solid investment vehicles are nowlooked upon as carrying great risk. A derivative is a financial instrument that allocates therisks and price exposures associated with a designated asset between the parties to aninstrument. Derivatives can provide price exposure or price insulation to changes in the price or level of an open-ended range of assets, including stocks, interest rates,currencies, bonds, commodities, insured risks, credit risks, investment funds, property,the weather and more. Derivatives are used in an infinite variety of ways by commercial,eleemosynary and governmental entities to manage the commercial and financial risksthey confront. As the breadth and complexity of derivatives evolve, so too does thecomplexity of associated documentation and legal issues. Swaps The first swaps were negotiated in the early 1980s. David Swensen, a Yale Ph.D. atSalomon Brothers, engineered the first swap transaction according to When GeniusFailed: The Rise and Fall of Long-Term Capital Management by Roger Lowenstein.Today, swaps are among the most heavily traded financial contracts in the world.In finance, a swap is a derivative in which two counterparties exchange certain benefitsof one party's financial instrument for those of the other party's financial instrument. The benefits in question depend on the type of financial instruments involved. Specifically,the two counterparties agree to exchange one stream of cash flows against another stream. These streams are called the legs of the swap. The swap agreement defines thedates when the cash flows are to be paid and the way they are calculated. Usually at thetime when the contract is initiated at least one of these series of cash flows is determined by a random or uncertain variable such as an interest rate, foreign exchange rate, equity price or commodity price.2  The cash flows are calculated over a notional principal amount, which is usually notexchanged between counterparties. Consequently, swaps can be used to create unfundedexposures to an underlying asset, since counterparties can earn the profit or loss frommovements in price without having to post the notional amount in cash or collateral.Swaps can be used to hedge certain risks such as interest rate risk, or to speculate onchanges in the expected direction of underlying prices. Traditionally, the exchange of onesecurity for another to change the maturity (bonds), quality of issues (stocks or bonds), or  because investment objectives have changed. If firms in separate countries havecomparative advantages on interest rates, then a swap could benefit both firms. For example, one firm may have a lower fixed interest rate, while another has access to alower floating interest rate. These firms could swap to take advantage of the lower rates Swap Market Most swaps are traded over-the-counter (OTC), tailor-made for the counterparties.Some types of swaps are also exchanged on futures markets such as the ChicagoMercantile Exchange Holdings Inc., the largest U.S. futures market, the Chicago BoardOptions Exchange, Intercontinental Exchange and Frankfurt-based Eurex AG.The Bank for International Settlements (BIS) publishes statistics on the notional amountsoutstanding in the OTC derivatives market. At the end of 2006, this was USD 415.2trillion, more than 8.5 times the 2006 gross world product. However, since the cash flowgenerated by a swap is equal to an interest rate times that notional amount, the cash flowgenerated from swaps is a substantial fraction of but much less than the gross world product -- which is also a cash-flow measure. The majority of this (USD 292.0 trillion)was due to interest rate swaps. These split by currency as:3  The CDS and currency swap markets are dwarfed by the interest rate swap market. Allthree markets peaked in mid 2008. Types of S waps The five generic types of swaps, in order of their quantitative importance, are:i. Interest Rate Swapsii. Currency Swapsiii.Credit Swapsiv.Commodity Swaps Andv.Equity Swaps..4