Swaps Risk and Exposure

The great bulk of swap activity of date has concentrated on currencies and interest rates, yet these do not exhaust the swap concept’s applicability. As one moves out the yield curve, the primary interest rate swap market becomes dominated by securities transactions and in particular the Eurodollar bond market. The advent of the swap market has meant that the Eurodollar bond market now never closes due to interest rate levels: issuers who would not come to market because of high interest rates now do so to the extent that a swap is available. Indeed, the Eurodollar bond market owes much of its spectacular growth to the parallel growth of its swap market. The firms that now dominate lead management roles in the Eurodollar bond market all have substantial swap capabilities and this trend will continue. One extension is seen in the beginning of the market for equity swaps- an exchange of coupons on some bonds for dividends on some equities, or an index instrument thereof (capital appreciation also may be included on one or both sides of the swap). The purpose is to earn equity returns when the investor deems them promising but without the transactions costs of liquidating an existing bond position or building an outright equities position, while also providing the complication of unfamiliar local market and the time and trouble of stock-picking if the index will suffice. Equity swaps (and, indeed, all swaps) further may be enhanced by options features customized to the interests of the credit worthy, sophisticated investor.

Essentials for reducing Swap risks

There are certain precautions which are suggested to be taken to reduce the swap risk. They are as follows:

  1. Undertaking more stringent credit analyses and use greater care in selecting counter-parties: This provides the best insurance against the swap risk. Having a financially strong counter party not only minimizes the chances of default but also facilitates the transfer of a swap, for either profit or lack of need, or both.
  2. Master agreements: These stipulate the all swaps between two parties are cross-defaulted to each other, default on any one swap triggers suspension payments on all others covered in the agreement. Such arrangements normally pre-suppose frequent transactions between the parties. They also are most effective in reducing exposure when a balance exists in swap positions between paying and receiving fixed rate flows, and between notional principal amounts and maturities.
  3. Collateralization: Collateralization with marketable securities has become an essential feature of swaps with dubious credits. The right to call can be mutual which normally applies only in one direction, depending on the relative strength of the two parties.
  4. Better documentation: More protective documentation in swap agreements can provide trigger points for remedial action in advance of actual default. Users could require, for example, that the various tests of financial condition found in credit agreements can provide trigger points for remedial action in advance of actual default. Users could require, for example, that the various tests of financial condition found in credit agreement are incorporated into swaps contracts.
  5. Net settlements: To minimize risk, a swap user is will advised to insist on settlement of all payments on the same day and on a net basis. A payments lag can leave a user vulnerable to loss of its counter-party defaults before the corresponding payment has been made.

Credit: International Finance Notes-MGU

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