UNIT: FINANCE 563
PRESENTATION FOR THE 7TH OF OCTOBER, 92
By Jo Rao Voola and Sanjeev Sabhlok
THE EVOLVING MARKET FOR SWAPS
by Clifford W. Smith, Jr.,
Charles W. Smithson, and
Lee Macdonald Wakeman
INTRODUCTION:
Def:1. A swap is an exchange of cash flows over time between two counterparties. (Smith et al:252)
2.A foreign exchange swap is an agreement between two parties to exchange a given amount of one currency for another and, after a period of time, to give back the original amounts swapped. (Eiteman:213)
Classification and Nomenclature of swaps: (Das, 1989:17)
Swaps can take place both in the domestic and international markets. They are of FOUR types:
1.parallel or back-to-back loans
2.swap transactions, comprising of
icredit swaps,
iicurrency swaps,
iiicurrency coupon swaps,
ivinterest rate swaps,
vbasis rate swaps,
vicommodity swaps,
viiswaps with timing mismatches,
viiiswaps with option-like payoffos (swapations),
ixamortising swaps,
xzero swaps,
xilong-dated or long-term foreign exchange contracts
(LTFX), etc.
3.forward rate agreements (FRAs)
4.caps, collars and floors
WE SHALL ONLY LOOK AT SOME SWAP TRANSACTIONS HERE.
These are not the only swaps which exist or are possible to invent. "the future potential structures (of swaps) ... are limited only by the imagination and ingenuity of those participating in the market." (Bankers Trust Company: cited by Smith et al:256)
A useful method of representing swaps:
Let A be a company located in the UK, and
B be a company located in the USA.
Firm A needs US dollars for some purpose and firm B needs pound sterling for some of its operations. They could borrow in the international financial markets, and face foreign exchange exposure, or alternately, lend each other the amounts with fixed interest repayments scheduled over a period of time. These repayments need not be equal. In actual practice, only the difference in the values of these payments (net cash flow) is paid, not the entire interest.
***We take a look at figures 1 and 2:
FOUR QUESTIONS ON SWAPS:
QUESTION ONE:
HOW DOES THE SWAP MARKET RELATE TO OTHER FINANCIAL MARKETS?
1.Relationship with forward contracts:
ALL swaps can be decomposed into a series of forward contracts.
***In Figure 2 (currency swap) the firm B, located in the US, pays fixed rate interest in pounds and receives fixed rate interest in dollars. In this case, each of the cash flows for firm B (LOCATED IN THE USA) are equivalent to those from holding a LONG POSITION IN DOLLARS in a pound-dollar forward contract. The effect of a fixed rate currency swap is to change a debt in pounds into a fully hedged fixed rate liability in dollars. (See Figure 7)
***In Figure 3 (Interest rate swap) the exchanges of principal flows at time 0 and time T add to zero because they are of the same amount in the same currency.
The similarity with forward contracts emerges more clearly when we look at the PAYOFF PROFILE of an interest rate swap. (Figure 4)
2.Relationship with Options:
***Some swaps have similar payoffs as options. These are the floating floor-ceiling and the fixed floor-ceiling swaps. Figures 4 and 5 illustrate these.
QUESTION TWO:
WHY, AND HOW, DID THE SWAP MARKET EVOLVE?
Part A: WHY DID THE SWAP MARKET EVOLVE?
1.Financial or Capital Market Arbitrage:
* Due to financial arbitrage across different capital markets. Firms might get lower rates abroad than at home.
* Problem: The process of exploiting an arbitrage opportunity should eliminate it. Instead, swap markets are increasing.
2.Tax and Regulatory Arbitrage:
Governments differ in their tax and regulations on economic activities. The tax treatment for different kinds of bonds and swaps differs (e.g. in Japan, zero coupon yen bonds were treated liberally). Hence, synthetic hedges are created. Figure 6 illustrates how a synthetic deep discount dollar bond is created out of a combination of four transactions.
3.Exposure Management:
Swaps are an excellent hedging tool as we have seen in Figure 7.
4.Completing Markets:
Often, swaps have emerged to fill "gaps" in the financial markets. (e.g. there were no interest rate forward contracts, but the interest rate swap has filled the gap)
5.Agency Costs:
Juttner cites Arak et al. 1988 to show that investors demand compensation in the form of a greater risk premium for long-term debt. Low-rate borrowers can avoid this penalty by issuing short-term securities and swapping these into fixed-rate payments.
6.Lending institutions are reluctant to lend at fixed rates for long terms, preferring floating rate loans.
Part B: HOW DID THE SWAP MARKET EVOLVE?
1.Credit swaps:
According to Eiteman:217, the first type of swap prevalent in the international markets was the credit swap. "The concept of a credit swap has been used for more than half a century between commercial banks, and between commercial banks and central banks, to satisfy temporary bank needs for foreign exchange."
2.Parallel and Back-to-back loans:
These then evolved in the early 1970s to the £ and US$ parallel loans arranged between British and American organisations.
3.Currency Swaps:
The first currency swap took place in Europe between the Dutch Guilder and the £ in 1976. These were customised, and intermediaries undertook no capital risk. The first intermediaries were investment banks. This has of course changed dramatically now. By end of 1989, the total value of amount outstanding in currency swaps had reached $494 billion. (Eiteman:333)
4.Interest Rate Swaps:
The first interest rate swap was transacted in 1981. The first interest rate swaps in Australian dollars were transacted only in 1983.
Interest rate swaps have become standardised and homogeneous. Intermediaries began to accept swap contracts without a counterparty, and took on risk. These intermediaries were commercial banks. Now, swaps are a high volume, low margin business. A 24-hour market now exists for dollar interest rate swaps of upto 12 year maturities. By the end of 1988 the market for interest rate swaps had grown to over $1 trillion, with additional $390 billion in new swaps negotiated in the first few months of 1989 (Eiteman:333)