Economics of Bond and Derivatives Markets - Swap Contracts - Essay Example

Introduction

A swap is a contract that exists between two parties whereby they undertake to exchange financial instruments. Swaps usually involve a flow of cash, and they are based on a notional principal amount in which the parties have an agreement. In the case of a swap, the principal amount does not change hands. Every part of the cash flow usually has a leg of the swap. There is usually a cash flow that is fixed, and the other is usually variable. The cash flow is usually based on a benchmarking interest rate, index price or a currency exchange rate. There are various types of swaps, but the most common are the interest rate swap. Swaps are usually not engaged in exchanges, and that means that retail investors who do not take part in swaps. Swaps are considered over the counter, and they exist between financial institutions or businesses (Paul, 2008, p 145).

Under interest rate swaps, parties usually exchange cash flows based on a principal for the parties to hedge against any interest rate risks or for purposes of speculation. Commodity swaps usually involve the exchange of commodity whereby the transferred cash flows depends on the price of an underlying commodity, for instance, the price of oil. The swap is usually set at a price that is agreed upon. The swap is usually common in petroleum products. Under currency swaps, parties involved often engage in the exchange of principal amounts and interest that are made on debt and have different denominations. It is different from the interest rate swap in that the principal amount is exchanged with the interest.

The swap is common among countries. The engage in them in an attempt to help in stabilizing the foreign reserves of a country. The other type of swap is the debt-equity swap that involves the exchange if equity for debt. In the situation of a company that is publicly traded, the swap would mean the exchange of bonds for stocks or the other way round. It is usually a means of refinancing debt. The other type of swap is the total return swap in which the return for an asset is exchanged for a rate of interest that is fixed. The swap usually gives the party that takes part in the fixed rate to an exposure that underlies in the asset (Hull, 2008, p 180).

Characteristics of swaps

Swaps usually involve payments with a monetary value attached to them. However, contracts that have a single payment are also possible. Swaps also involve a series of contracts that are forward.

The other characteristic of swaps is that they whenever they are initiated, no party physically exchanges any form of cash. That means that a swap has a value that is equal to zero at the beginning of the contract. In a swap contract, there is a party that seems to pay a rate that is fixed while the other party pays upon the movement of the asset that is being considered. However, there are cases in which swaps can be structured in such a way that both parties pay each other when there is a movement of the asset under consideration.

Also, swap contract involves a fixed settlement date in which each party makes its payment. There are situations in which parties can agree to exchange the difference that is due to the other. The situation is known as netting. Under swaps, the payment that is final is made on the date in which the contract is terminated. Swaps are usually traded over the counter, and that means that they are subject to a credit risk.

Termination of a swap contract

The best way of terminating a swap is holding it until maturity. However, there are cases in which a party may want to terminate the contract before maturity. There are various methods of terminating the contract. The methods include,

• The parties are entering into a swap that is separate and that offsets the previous swap.
• Parties can also have a cash settlement based on the prevailing market rates.
• A party can also sell the existing swap to a different party. The agreement will require a permission been granted by the other party.
• The other method of terminating a swap is by the use of a swaption. A swaption is usually an option in which the owner has the right to enter into a different swap under the underlying terms that had been set in advance.

Control of financial risks by swaps

Swap contracts are entered in an attempt to avoid financial risks that are involved in the financial market. The financial risks that exist include credit risks, currency fluctuation risks, interest rate risk, as well as opportunity cost risk. A swap is used in mitigating the credit risk of a company. The company usually have a co-contractor who acts on behalf of the company. That means that if one party in the contract becomes bankrupt, then the co-contactor will compensate for the loss. That means that the loss will be borne by the co-contractor.

Currency fluctuation risk is the other financial risk usually hedged through swap contracts. In a case whereby different countries are exchanging in foreign trade, there is a risk that exists because of fluctuation in the currencies of the individual countries. That means that there is a risk that one country may lose in value if its currency weakens against the other currencies. That means that the companies can enter into a swap contract that will mitigate the loss that will be incurred in case of a loss in the value of its currency.

The other financial risks that are hedged by swap contact is the interest rate risk. To hedge risk using an interest rate swap, parties in a contract agree the rate of future interest payments basing it on a specific principal amount. Effectively, the interest rate swap is used to ensure that increase in interest rates does not affect parties that are doing business. The other risk that is involved in business is the opportunity. A swap is usually a form of a bet. That means that if the swap works in your favor, that that will be a gain or an advantage on your part (Pirrong, 2005, p 200).

Shortcomings of swap contracts

Swaps are associated with the advantage that arises from hedging different financial risks. However, hedging financial risk comes with various disadvantages. One disadvantage is that swap contracts are a form of gamble. This is because swaps are placed on a bet. In a case whereby a company wants to lock itself in a market that has a low rate that is uncertain, then they can take part in a swap contract under which the rates are higher but stable. That means that there is no opportunity for savings. The parties may also loose when they take part in a swap contract, and that makes it a gamble. However, if the bet works on the advantage of a certain party, then the party will be at an advantage (Coggan, 2008, p 67).

The other disadvantage is about the opportunity risk. When a company takes part in a swap contract that involves bonds, there are instances in which cash is held up in a contract while there are better developments that are happening in a different place. That means that the company will lose on the probable gain they would have made if they had invested in a different venture. If a party is worried about loan rates that are variables and seek rates that are more stable in a different market, then f the market loses the company will lose. A swap should be used by an investor who is conservative and is willing to take a rate that is higher for the sake of stability. This happens when the investor hopes that the rates will appreciate in his favor (Sharly, 2008, p 90).

Another disadvantage is that the contracts are long term. Interest rate swaps are involved in long-term lending problems. The swap market was developed in the 80’s because of the recession that took place in the 70’s. The recession forced banks to become cautious about their commitments that are long term. Investors were forced to venture into new markets that offered long-term rates. The investors have the ability to get higher rates. However, their cash will be locked into rates that are long term and tolerable. The disadvantage of the gamble is that if the part of the swap that is variable goes down, then the investor will lose. The parties in the contract want to save their money in undertaking the obligation (Stulz, 2007, p 190).

The other disadvantage of the swap contract is the issue of credit risks. Interest rate swaps were developed because of loans that had variable interest rates and were nerve cracking because of their long-term engagement. Investors who were conservatives did not like the ideas, and that gave them the will to pay more for security. At the same time, some of the investors were willing to bet on changes in the interest rate, and that meant that they had fewer obligations. The interest swap concept said that the investors were betting in the credit worth of their co-contractor. If the co-contractor defaulted in the payment of the loan, the loan would become expensive for them to service. That was a disadvantage because they will not get payment from the other party (Deborah, 2006, p 13).

The other disadvantage of swaps is that they are associated with breakage costs. That means that a party that breaks the contract will incur a cost that they may not have planned for. The other disadvantage is that parties that engage in the contract usually get liquidity problems. This is because most of their cash is tied up in the contract.

Interest rate swap

The swap contract that has been chosen for the paper is the interest rate swap. The contract is an agreement that is made between parties in which there is a stream that has future payments of interest that are exchanged for a principal amount that is specified in the contract. The swaps usually exchange payment rate they are for a payment that is floating and fixed to an interest rate. Companies use the contract to manage exposures that arise from fluctuations in the rate of interest. They are aimed at obtaining an interest rate that is less and that they can afford (Stulz, 2010, p73).

The contract is an exchange of cash flows for others. This is because they trade OTC. There are contracts that are set between two parties, or more and that means that they can be customized in some ways.

Structure of the interest rate swap

In the contract, each party has to agree on either a floating rate or a rate that is fixed and the rates are put in a specified currency. The rate that is fixed is usually multiplied by a principal amount that is usually notional and a factor that accrues and it is given by a convention based on day count. In a case where the legs are in the same currency, then the amount that is notional is usually not exchanged the amount is usually used for calculating the cash flow size that is used in the exchange (Acharya, 2009, p 90). In a case whereby the legs are in different currencies, the notional amounts are usual exchanged at the end and start of the swap. The transaction is called cross-currency swap.

Since swaps are OTC instruments, there are available in different varieties. The interest swaps can be structured in a manner to meet the needs that are specified by the counterparties. This means that the legs in the swap can be in the same currency of different. The other available variety is a case whereby the notional amount can be amortized with time, and the dates can be reset in an irregular manner. Swaps are financial instruments that work in a similar manner as other derivatives, and they were established in an attempt to lower the financial risks that exist in the financial markets (Williams, 2007, p 108).