SWAPS

admin — Wed, 17 Nov 2010 11:01:02 +0000

A swap is an agreement whereby two parties (called counterparties) agree to exchange periodic payments. The dollar amount of the payments exchanged is based on some predetermined dollar principal, which is called the notional principal amount or notional amount. The dollar amount each counterparty pays to the other is the agreed-upon periodic rate times the notional principal amount. The only dollars that are exchanged between the parties are the agreed-upon payments, not the notional principal amount. In a swap, there is the risk that one of the parties will fail to meet its obligation to make payments (default). This is referred to as counterparty risk.
Swaps are classified based on the characteristics of the swap payments. There are four types of swaps: interest rate swaps, interest rate-equity swaps, equity swaps, and currency swaps. In an interest rate swap, the counterparties swap payments in the same currency based on an interest rate. For example, one of the counterparties can pay a fixed-interest rate and the other party a floating interest rate. The floating-interest rate is commonly referred to as the reference rate. In an interest rate-equity swap, one party is exchanging a payment based on an interest rate and the other party based on the return of some equity index. The payments are made in the same currency. In an equity swap, both parties exchange payments in the same currency based on some equity index. Finally, in a currency swap, two parties agree to swap payments based on different currencies.
A swap is not a new derivative instrument. Rather, it can be decomposed into a package of forward contracts. While a swap may be nothing more than a package of forward contracts, it is not a redundant contract for several reasons. First, in many markets where there are forward and futures contracts, the longest maturity does not extend out as far as that of a typical swap. Second, a swap is a more transactionally efficient instrument. By this we mean that in one transaction an entity can effectively establish a payoff equivalent to a package of forward contracts. The forward contracts would each have to be negotiated separately. Third, the liquidity of some swap markets is now better than many forward contracts, particularly long-dated (i.e., long-term) forward contracts.

MARKET OR TRADING RISK

admin — Fri, 02 Oct 2009 14:32:40 +0000

Every year a handful of banks make sufficiently large trading losses to make the non-business sections of the media take note. The surprising thing is not that some banks make large trading losses but how few very large losses are incurred, given the sheer volume of financial trading activities. Very few of the actual losses reported have been sufficiently large to threaten the solvency of the financial institutions concerned.
This state of affairs owes less to the skills of traders and more to the effectiveness and generally high standard of controls put in place to manage market risks. Most of the reported large losses have occurred as a result of fraud at banks where line management has not understood the nature of the risks being taken and failed to implement some of the most basic controls necessary. Single traders have been able to run up losses amounting to several hundred million dollars without anyone noticing. The traders concerned have, of course, taken the rap but the real finger of blame should be pointed in the direction of management.
Trading portfolio risks can be conveniently broken down into three parts: first order price risks, realization risks and model risks. These incorporate our more familiar definitions of interest rate risk, foreign exchange risk, counterparty risk and so on.

Loans and money issues » debt

SWAPS

MARKET OR TRADING RISK