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Swaps

Swaps are a fundamental financial tool to exchange flows of capital at multiple times for a specified period of time. In any case there are at least two parties agreeing to exchange a notional principal at the beginning and end of the swap as well as paying a defined interest periodically. Swaps can be used to transform cash flows or to hedge against interest rate or exchange rate risks. The most simple form of a swap is a Bond (Finance). Most swaps are negotiated OTC (over the counter) between financial institutions or at least with a financial intermediary. The notional principle outstanding of all swaps is multiple times (more than 8) higher than the worlds GDP.

Plain Vanilla interest rate swap

A very common swap is the Plain Vanilla, which is an interest rate swap in which one party agrees to pay a floating rate to a party which in turn pays a fixed rate. Due to the fact that fixed rates to not occur naturally, large banks need to do hedge themselves using such a swap to offer fixed rate loans for example to retail clients.

Valuation

Swaps are valued by discounting the expected cash flows to the present date. Due to the fact that these are positive as well as negative, this means that the value of a swap can also be positive or negative. This leads to an interesting phenomenom when it comes to the question of counterparty risk. Is the swap value negative the “risk” of bankruptcy of the counterparty might actually be a “chance” in that the swap payments would be terminated. Swaps can also be valuated by splitting them into bonds and then seperately valueing these bonds.

Currency swap

A currency swap exchanges interest payments in one currency for interest payments in another. They can thus be used to hedge an exchange rate risk, which companies involved in international trade are often exposed to. The following example will explain such a situation:

A chinese oil power plant needs large amounts of crude oil in very regular time intervalls. The oil has to be paid in US dollars, the company, however, sells its product, electricity, in chinese yuan. If we consider a projected acquisition of oil in 6 months time, the company would face the risk that the dollar appreciates in value during those 6 months, making the aquisition of oil more expensive for the company which has its income in yuan. It might then decide to negotiate a currency swap at present time, which in thise case would appreciate in value if the dollar increases, thus offsetting the loss on the more costly acqusition of oil. In this case the company might also consider negotiating a commodity swap to hedge its exposure to the oil price.

CDS (Credit default swap)

CDS are a special kind of swap that lets its buyer insure against a credit risk of a third party or reference bond. The buyer will pay a fee anually. The issuer pays a negotiated compensation in case of a default event, which can also be exactly defined. CDS have gained significant importance as an indicator of credit worthiness of companies and have recently become famous in relation to credit problems of countries.

CDS spread

The “spread” is the fee that the buyer of a CDS has to pay regularly to the issuer of the CDS. It is also used as an indicator of credit worthiness of companies, organisations or countries and often measures the interest a bank will pay on deposits. That interest is usually a reference rate, such as the LIBOR or EURIBOR plus the CDS spread (which will be higher if the bank is less credit-worthy) plus a liquidity spread.

Criticism and speculation

Because the buyer of a CDS does not have to own the underlying reference bond, CDS are frequently used to speculate on the bankruptcy of an entity. This has evoked a large amount of criticism from the general media and financial commentators.

Commerce


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