Understanding the Financial Swaps Market

Exchange rate instability and the collapse of the Bretton Woods System and particularly the control over the movement of the capital internationally, paved the way for the origin of the financial swaps market. To day swaps are at the center of the global financial revolution. The growth is such that sometimes it looks like unbelievable but it is true. Though its growth will continue or not is doubtful. Already the shaking has started. In the “plain vanilla” dollar sector, the profits for brokers and market makers, after costs and allocation of risk capital, are measured in fewer than five basis points. This is before the regulators catch up and force disclosure and capital haircuts. At these spreads, the more highly paid must move on to currency swaps, tax-driven deals, tailored structures and schlock swaps.

The fact which is certain is that, although the excitement may diminish, swaps will stay. Already, swaps have had a major macro economic impact forging the linkage between the euro and the domestic markets, flattening the cash yield curves, and reducing central bank monopoly influence on markets. We are all swappers now and remember the saying “beware of honey offered on a sharp knife” when you are offered sweet deals. The problem in following the chaotic process of this very important market is quite simply that “he who knows does not speak, he who speaks does not know.”

The concept of the SWAPS

The aim of a swap contract is to bind the two counter-parties to exchange two different payment streams over time, the payment being tied, or at least in part, to subsequent-and uncertain-market price developments. In most swaps so far, the prices concerned have been exchange rates or interest rates, but they increasingly reach out to equity indices and physical commodities. All such prices have risk characteristics in common, in quality if not degree. And for all, the allure of swaps may be expected cost saving, yield enhancement, or hedging or speculative opportunity.

Portfolio management requires financial swaps which are simple in principle, versatile in practice yet revolutionary. A swap coupled with an existing asset or liability can radically modify effective risk and return. Individually and together with futures, options and other financial derivatives, they allow yield curve and currency risks, and liquidity and geographic market considerations, all to be managed separately and also independently of underlying cash market stocks.

Growth of the SWAP Market

In the international finance market most of the new products are executed in a physical market but swap transactions are not. Participants in the swap market are many and varied in their location character and motivates in exciting swaps. However, in general the activity of the participants in the swap market have taken on the character of a classical financial market connected to, and integrating the underlying money, capital and foreign exchange market.

Swap in their current form started in 1981 with the well-publicized currency swaps, and in the following year with dollar interest rate swaps. The initial deals were characterized by the three critical features.

  1. Barter– two counter-parties with exactly offsetting exposures were introduced by a third party. If the credit risk were unequal, the third party- if a bank – might interpose itself or arrange for a bank to do so for a small fee.
  2. Arbitrage driven– the swap was driven by a arbitrage which gave some profit to all three parties. Generally, this was a credit arbitrage or market access arbitrage.
  3. Liability driven– almost all swaps were driven by the need to manage a debt issue on both sides.

The major dramatic change has been the emergence of the large banks as aggressive market makers in dollar interest rate swaps. Major US banks are in the business of taking credit risk and interest rate risk. They, therefore, do not need counter-parties to do dollar swaps. The net result is that spreads have collapsed and volume has exploded. This means that institutional investors get a better return on their investments and international borrowers pay lower financing costs. This, in turn, result in more competitively priced goods for consumers and in enhanced returns pensioners. Swap therefore, have an effect on almost all of us yet they remain an arcane derivative risk management tool, sometimes suspected of providing the international banking system with tools required to bring about destruction.

Although the financial swaps market is now firmly established, there remains a wide divergence among current and potential users as to how exactly a given swap structure works, what risks are entailed when entering into swap transactions and precisely what “the swap market” is and, for that matter is not.

The basic SWAP Structures

The growth and continued success of the financial swaps market has been due small part to the creativity of its participants. As a result, the swaps structures currently available and the future potential structures which will in time become just another market “norm” are limited only by the imagination and ingenuity of those participating in the market. Nonetheless, underlying the swap transactions seen in the financial swaps market today are four basic structures which may now be considered as “fundamental”. These structures are (1) the Interest Rate Swap, (2) the Fixed Rate Currency Swap, (3) the Currency Coupon Swap and (4) the Basis Rate Swap.