Swap

SWAP

In finance, a swap is a derivative in which counterparties exchange certain benefits

of one party's financial instrument for those of the other party's financial

instrument. The benefits in question depend on the type of financial instruments

involved. For example, in the case of a swap involving two bonds, the benefits in

question can be the periodic interest (or coupon) payments associated with the

bonds. Specifically, the two counterparties agree to exchange one stream of cash

flows against another stream. These streams are called the legs of the swap. The

swap agreement defines the dates when the cash flows are to be paid and the way

they are calculated. Usually at the time when the contract is initiated at least one of

these series of cash flows is determined by a random or uncertain variable such as

an interest rate, foreign exchange rate, equity price or commodity price.

The cash flows are calculated over a notional principal amount, which is usually

not exchanged between counterparties. Consequently, swaps can be in cash or

collateral. Swaps can be used to hedge certain risks such as interest rate risk, or to

speculate on changes in the expected direction of underlying prices.

The first swaps were negotiated in the early 1980s.David Swensen, a Yale Ph.D. at

Salomon Brothers, engineered the first swap transaction according to "When

Genius Failed: The Rise and Fall of Long-Term Capital Management" by Roger

Lowenstein. Today, swaps are among the most heavily traded financial contracts in

the world: the total amount of interest rates and currency swaps outstanding is

more thаn $426.7 trillion in 2009, according to International Swaps and

Derivatives Association.

SWAP MARKET

Most swaps are traded over-the-counter (OTC), "tailor-made" for the

counterparties. Some types of swaps are also exchanged on futures markets such as

the Chicago Mercantile Exchange Holdings Inc., the largest U.S. futures market,

the Chicago Board Options Exchange, IntercontinentalExchange and Frankfurt-

based Eurex AG. The Bank for International Settlements (BIS) publishes statistics

on the notional amounts outstanding in the OTC derivatives market. At the end of

2006, this was USD 415.2 trillion, more than 8.5 times the 2006 gross world

product. However, since the cash flow generated by a swap is equal to an interest

rate times that notional amount, the cash flow generated from swaps is a

substantial fraction of but much less than the gross world product—which is also a

cash-flow measure. The majority of this (USD 292.0 trillion) was due to interest

rate swaps. These split by currency as:

The CDS and currency swap markets are dwarfed by the interest rate swap market.

All three markets peaked in mid 2008.

Source: BIS Semiannual OTC derivatives statistics at end-December 2008

CurrencyEnd

2000

End

2001

End

2002

End

2003

End

2004

End

2005

End

2006

Euro 16.6 20.9 31.5 44.7 59.3 81.4 112.1

US dollar 13.0 18.9 23.7 33.4 44.8 74.4 97.6

Japanese yen 11.1 10.1 12.8 17.4 21.5 25.6 38.0

Pound

sterling4.0 5.0 6.2 7.9 11.6 15.1 22.3

Swiss franc 1.1 1.2 1.5 2.0 2.7 3.3 3.5

Total 48.8 58.9 79.2 111.2 147.4 212.0 292.0

Source: "The Global OTC Derivatives Market at end-December 2004", BIS,

"OTC Derivatives Market Activity in the Second Half of 2006", BIS.

Usually, at least one of the legs has a rate that is variable. It can depend on a

reference rate, the total return of a swap, an economic statistic, etc. The most

important criterion is that it comes from an independent third party, to avoid any

conflict of interest. For instance, LIBOR is published by the British Bankers

Association, an independent trade body.

Types of swaps

The five generic types of swaps, in order of their quantitative importance, are:

interest rate swaps, currency swaps, credit swaps, commodity swaps and equity

swaps. There are also many other types.

Interest rate swaps -:

Main article: Interest Rate Swap

A is currently paying floating, but wants to pay fixed. B is currently paying fixed

but wants to pay floating. By entering into an interest rate swap, the net result is

that each party can 'swap' their existing obligation for their desired obligation.

Normally the parties do not swap payments directly, but rather, each sets up a

separate swap with a financial intermediary such as a bank. In return for matching

the two parties together, the bank takes a spread from the swap payments.

The most common type of swap is a “plain Vanilla” interest rate swap. It is the

exchange of a fixed rate loan to a floating rate loan. The life of the swap can range

from 2 years to over 15 years. The reason for this exchange is to take benefit from

comparative advantage. Some companies may have comparative advantage in

fixed rate markets while other companies have a comparative advantage in floating

rate markets. When companies want to borrow they look for cheap borrowing i.e.

from the market where they have comparative advantage. However this may lead

to a company borrowing fixed when it wants floating or borrowing floating when it

wants fixed. This is where a swap comes in. A swap has the effect of transforming

a fixed rate loan into a floating rate loan or vice versa.

For example, party B makes periodic interest payments to party A based on a

variable interest rate of LIBOR +70 basis points. Party A in return makes periodic

interest payments based on a fixed rate of 8.65%. The payments are calculated over

the notional amount. The first rate is called variable, because it is reset at the

beginning of each interest calculation period to the then current reference rate, such

as LIBOR. In reality, the actual rate received by A and B is slightly lower due to a

bank taking a spread.

Currency swaps -:

Main article: Currency swap

A currency swap involves exchanging principal and fixed rate interest payments on

a loan in one currency for principal and fixed rate interest payments on an equal

loan in another currency. Just like interest rate swaps;the currency swaps also are

motivated by comparative advantage.

Commodity swaps -:

Main article: Commodity swap

A commodity swap is an agreement whereby a floating (or market or spot) price is

exchanged for a fixed price over a specified period. The vast majority of

commodity swaps involve crude oil.

Equity Swap -:

Main article: equity swap

An equity swap is a special type of total return swap, where the underlying asset is

a stock, a basket of stocks, or a stock index. Compared to actually owning the

stock, in this case you do not have to pay anything up front, but you do not have

any voting or other rights that stock holders do have.

Credit default swaps -:

Main article: Credit default swap

A credit default swap (CDS) is a swap contract in which the buyer of the CDS

makes a series of payments to the seller and, in exchange, receives a payoff if a

credit instrument - typically a bond or loan - goes into default (fails to pay). Less

commonly, the credit event that triggers the payoff can be a company undergoing

restructuring, bankruptcy or even just having its credit rating downgraded. CDS

contracts have been compared with insurance, because the buyer pays a premium

and, in return, receives a sum of money if one of the events specified in the

contract occur. Unlike an actual insurance contract the buyer is allowed to profit

from the contract and may also cover an asset to which the buyer has no direct

exposure.

Uses

Credit default swaps can be used by investors for speculation, hedging and

arbitrage.

Speculation

Credit default swaps allow investors to speculate on changes in CDS spreads of

single names or of market indices such as the North American CDX index or the

European iTraxx index. An investor might believe that an entity's CDS spreads are

too high or too low, relative to the entity's bond yields, and attempt to profit from

that view by entering into a trade, known as a basis trade, that combines a CDS

with a cash bond and an interest-rate swap.

Hedging

Credit default swaps are often used to manage the risk of default which arises from

holding debt. A bank, for example, may hedge its risk that a borrower may default

on a loan by entering into a CDS contract as the buyer of protection. If the loan

goes into default, the proceeds from the CDS contract will cancel out the losses on

the underlying debt.

Arbitrage

Capital Structure Arbitrage is an example of an arbitrage strategy that utilizes

CDS transactions.This technique relies on the fact that a company's stock price and

its CDS spread should exhibit negative correlation; i.e. if the outlook for a

company improves then its share price should go up and its CDS spread should

tighten, since it is less likely to default on its debt. However if its outlook worsens

then its CDS spread should widen and its stock price should fall. Techniques

reliant on this are known as capital structure arbitrage because they exploit market

inefficiencies between different parts of the same company's capital structure; i.e.

mis-pricings between a company's debt and equity. An arbitrageur will attempt to

exploit the spread between a company's CDS and its equity in certain situations

Naked credit default swaps

In the examples above, the hedge fund did not own debt of Risky Corp. A CDS in

which the buyer does not own the underlying debt is referred to as a naked credit

default swap, estimated to be up to 80% of the credit default swap market. There is

currently a debate in the United States and Europe about whether speculative uses

of credit default swaps should be banned. Legislation is under consideration by

Congress as part of financial reform.

Critics assert that naked CDS should be banned, comparing them to buying fire

insurance on your neighbor’s house, which creates a huge incentive for arson.

Analogizing to the concept of insurable interest, critics say you should not be able

to buy a CDS-insurance against default when you do not own the bond. Short

selling is also viewed as gambling and the CDS market as a casino. Another

concern is the size of CDS market. Because naked credit default swaps are

synthetic, there is no limit to how many can be sold. The gross amount of CDS far

exceeds all “real” corporate bonds and loans outstanding. As a result, the risk of

default is magnified leading to concerns about systemic risk.

Other variations

There are myriad different variations on the vanilla swap structure, which are

limited only by the imagination of financial engineers and the desire of corporate

treasurers and fund managers for exotic structures.

A total return swap is a swap in which party A pays the total return of an

asset, and party B makes periodic interest payments. The total return is the

capital gain or loss, plus any interest or dividend payments. Note that if the

total return is negative, then party A receives this amount from party B. The

parties have exposure to the return of the underlying stock or index, without

having to hold the underlying assets. The profit or loss of party B is the same

for him as actually owning the underlying asset.

An option on a swap is called a swaption. These provide one party with the

right but not the obligation at a future time to enter into a swap.

A variance swap is an over-the-counter instrument that allows one to

speculate on or hedge risks associated with the magnitude of movement, a

CMS, is a swap that allows the purchaser to fix the duration of received

flows on a swap.

An Amortising swap is usually an interest rate swap in which the notional

principal for the interest payments declines during the life of the swap,

perhaps at a rate tied to the prepayment of a mortgage or to an interest rate

benchmark such as the LIBOR.

Valuation

Further information: Rational pricing#Swaps and Arbitrage

The value of a swap is the net present value (NPV) of all estimated future cash

flows. A swap is worth zero when it is first initiated, however after this time its

value may become positive or negative. There are two ways to value swaps: in

terms of bond prices, or as a portfolio of forward contracts.

Using bond prices

While principal payments are not exchanged in an interest rate swap, assuming that

these are received and paid at the end of the swap does not change its value. Thus,

from the point of view of the floating-rate payer, a swap position in a fixed-rate

bond (i.e. receiving fixed interest payments), and a short position in a floating rate

note (i.e. making floating interest payments):

Vswap = Bfixed − Bfloating

From the point of view of the fixed-rate payer, the swap can be viewed as having

the opposite positions. That is,

Vswap = Bfloating − Bfixed

Similarly, currency swaps can be regarded as having positions in bonds whose cash

flows correspond to those in the swap. Thus, the home currency value is:

Vswap = Bdomestic − S0Bforeign, where Bdomestic is the domestic cash flows of the

swap, Bforeign is the foreign cash flows of the LIBOR is the rate of interest

offered by banks on deposit from other banks in the eurocurrency market.

One-month LIBOR is the rate offered for 1-month deposits, 3-month LIBOR

for three months deposits, etc.

LIBOR rates are determined by trading between banks and change continuously as

economic conditions change. Just like the prime rate of interest quoted in the

domestic market, LIBOR is a reference rate of interest in the International Market.

Arbitrage arguments

As mentioned, to be arbitrage free, the terms of a swap contract are such that,

initially, the NPV of these future cash flows is equal to zero. Where this is not the

case, arbitrage would be possible.

For example, consider a plain vanilla fixed-to-floating interest rate swap where

Party A pays a fixed rate, and Party B pays a floating rate. In such an agreement

the fixed rate would be such that the present value of future fixed rate payments by

Party A are equal to the present value of the expected future floating rate payments

(i.e. the NPV is zero). Where this is not the case, an Arbitrageur, C, could:

1. assume the position with the lower present value of payments, and borrow

funds equal to this present value

2. meet the cash flow obligations on the position by using the borrowed funds,

and receive the corresponding payments - which have a higher present value

3. use the received payments to repay the debt on the borrowed funds

4. pocket the difference - where the difference between the present value of the

loan and the present value of the inflows is the arbitrage profit.

Constant maturity swap

A constant maturity swap, also known as a CMS, is a swap that allows the

purchaser to fix the duration of received flows on a swap.

The floating leg of an interest rate swap typically resets against a published index.

The floating leg of a constant maturity swap fixes against a point on the swap

curve on a periodic basis.

A constant maturity swap is an interest rate swap where the interest rate on one leg

is reset periodically, but with reference to a market swap rate rather than LIBOR.

The other leg of the swap is generally LIBOR, but may be a fixed rate or

potentially another constant maturity rate. Constant maturity swaps can either be

single currency or cross currency swaps. Therefore, the prime factor for a constant

maturity swap is the shape of the forward implied yield curves. A single currency

constant maturity swap versus LIBOR is similar to a series of differential interest

rate fix (or "DIRF") in the same way that an interest rate swap is similar to a series

of forward rate agreements. Valuation of constant maturity swaps depends on

volatilities and correlations of different forward rates and therefore requires an

interest rate model or some approximated methodology like a convexity

adjustment, see for example Brigo and Mercurio (2001).

Example

A customer believes that the difference between the six-month LIBOR rate will

fall relative to the three-year swap rate for a given currency. To take advantage of

this, he buys a constant maturity swap paying the six-month LIBOR rate and

receiving the three-year swap rate.

Sources of market data

Data about the credit default swaps market is available from three main sources.

Data on an annual and semiannual basis is available from the International Swaps

and Derivatives Association (ISDA) since 2001 and from the Bank for

International Settlements (BIS) since 2004. The Depository Trust & Clearing

Corporation (DTCC), through its global repository Trade Information Warehouse

(TIW), provides weekly data but publicly available information goes back only one

year.The numbers provided by each source do not always match because each

provider uses different sampling methods.

According to DTCC, the Trade Information Warehouse maintains the only "global

electronic database for virtually all CDS contracts outstanding in the marketplace."

The Office of the Comptroller of the Currency publishes quarterly credit derivative

data about insured U.S commercial banks and trust companies.

Finally, an investor might speculate on an entity's credit quality, since generally

CDS spreads will increase as credit-worthiness declines, and decline as credit-

worthiness increases. The investor might therefore buy CDS protection on a

company to speculate that it is about to default. Alternatively, the investor might

sell protection if it thinks that the company's creditworthiness might improve. The

investor selling the CDS is viewed as being “long” on the CDS and the credit, as if

the investor owned the bond.In contrast, the investor who bought protection is

“short” on the CDS and the underlying credit. Credit default swaps opened up

important new avenues to speculators. Investors could go long on a bond without

any upfront cost of buying a bond; all the investor need do was promise to pay in

the event of default.Shorting a bond faced difficult practical problems, such that

shorting was often not feasible; CDS made shorting credit possible and popular.

Because the speculator in either case does not own the bond, its position is said to

be a synthetic long or short position.

For example, a hedge fund believes that Risky Corp will soon default on its debt.

Therefore, it buys $10 million worth of CDS protection for two years from AAA-

Bank, with Risky Corp as the reference entity, at a spread of 500 basis points

(=5%) per annum.

If Risky Corp does indeed default after, say, one year, then the hedge fund

will have paid $500,000 to AAA-Bank, but will then receive $10 million

(assuming zero recovery rate, and that AAA-Bank has the liquidity to cover

the loss), thereby making a profit. AAA-Bank, and its investors, will incur a

$9.5 million loss minus recovery unless the bank has somehow offset the

position before the default.

However, if Risky Corp does not default, then the CDS contract will run for

two years, and the hedge fund will have ended up paying $1 million, without

any return, thereby making a loss. AAA-Bank, by selling protection, has

made $1 million without any upfront investment.

Note that there is a third possibility in the above scenario; the hedge fund could

decide to liquidate its position after a certain period of time in an attempt to realise

its gains or losses. For example:

After 1 year, the market now considers Risky Corp more likely to default, so

its CDS spread has widened from 500 to 1500 basis points. The hedge fund

may choose to sell $10 million worth of protection for 1 year to AAA-Bank

at this higher rate. Therefore over the two years the hedge fund will pay the

bank 2 * 5% * $10 million = $1 million, but will receive 1 * 15% *

$10 million = $1.5 million, giving a total profit of $500,000.

In another scenario, after one year the market now considers Risky much

less likely to default, so its CDS spread has tightened from 500 to 250 basis

points. Again, the hedge fund may choose to sell $10 million worth of

protection for 1 year to AAA-Bank at this lower spread. Therefore over the

two years the hedge fund will pay the bank 2 * 5% * $10 million =

$1 million, but will receive 1 * 2.5% * $10 million = $250,000, giving a

total loss of $750,000. This loss is smaller than the $1 million loss that

would have occurred if the second transaction had not been entered into.

Transactions such as these do not even have to be entered into over the long-term.

If Risky Corp's CDS spread had widened by just a couple of basis points over the

course of one day, the hedge fund could have entered into an offsetting contract

immediately and made a small profit over the life of the two CDS contracts.

Credit default swaps are also used to structure synthetic collateralized debt

obligations (CDOs). Instead of owning bonds or loans, a synthetic CDO gets credit

exposure to a portfolio of fixed income assets without owning those assets through

the use of CDS. CDOs are viewed as complex and opaque financial instruments.

An example of a synthetic CDO is Abacus 2007-AC1 which is the subject of the

civil suit for fraud brought by the SEC against Goldman Sachs in April 2010.

Abacus is a synthetic CDO consisting of credit default swaps referencing a variety

of mortgage backed securities.

Financier George Soros called for an outright ban on naked credit default swaps,

viewing them as “toxic” and allowing speculators to bet against and “bear raid”

companies or countries.His concerns were echoed by several European politicians

who, during the Greek Financial Crisis, accused naked CDS buyers as making the

crisis worse.

Despite these concerns, Secretary of Treasury Geithner and Commodity Futures

Trading Commission Chairman Gensler are not in favor of an outright ban of

naked credit default swaps. They prefer greater transparency and better

capitalization requirements.These officials think that naked CDS have a place in

the market.

Proponents of naked credit default swaps say that short selling in various forms,

whether credit default swaps, options or futures, has the beneficial effect of

increasing liquidity in the marketplace.That benefits hedging activities. Without

speculators buying and selling naked CDS, banks wanting to hedge might not find

a ready seller of protection. Speculators also create a more competitive

marketplace, keeping prices down for hedgers. A robust market in credit default

swaps can also serve as a barometer to regulators and investors about the credit

health of a company or country.

Despite politicians' assertions that speculators are making the Greek crisis worse,

Germany's market regulator BaFin found no proof supporting the claim.Some

suggest that without credit default swaps, Greece’s borrowing costs would be

higher.

There are other ways to eliminate or reduce the risk of default. The bank could sell

(that is, assign) the loan outright or bring in other banks as participants. However,

these options may not meet the bank’s needs. Consent of the corporate borrower is

often required. The bank may not want to incur the time and cost to find loan

participants. If both the borrower and lender are well-known and the market (or

even worse, the news media) learns that the bank is selling the loan, then the sale

may be viewed as signaling a lack of trust in the borrower, which could severely

damage the banker-client relationship. In addition, the bank simply may not want

to sell or share the potential profits from the loan. By buying a credit default swap,

the bank can lay off default risk while still keeping the loan in its portfolio. The

downside to this hedge is that without default risk, a bank may have no motivation

to actively monitor the loan and the counterparty has no relationship to the

borrower.

Another kind of hedge is against concentration risk. A bank’s risk management

team may advise that the bank is overly concentrated with a particular borrower or

industry. The bank can lay off some of this risk by buying a CDS. Because the

borrower—the reference entity—is not a party to a credit default swap, entering

into a CDS allows the bank to achieve its diversity objectives without impacting its

loan portfolio or customer relations.Similarly, a bank selling a CDS can diversify

its portfolio by gaining exposure to an industry in which the selling bank has no

customer base.

A bank buying protection can also use a CDS to free regulatory capital. By

offloading a particular credit risk, a bank is not required to hold as much capital in

reserve against the risk of default (traditionally 8% of the total loan under Basel.

This frees resources which the bank can use to make other loans to the same key

customer or to other borrowers.

Hedging risk is not limited to banks as lenders. Holders of corporate bonds, such as

banks, pension funds or insurance companies, may buy a CDS as a hedge for

similar reasons. Pension fund example: A pension fund owns five-year bonds

issued by Risky Corp with par value of $10 million. In order to manage the risk of

losing money if Risky Corp defaults on its debt, the pension fund buys a CDS from

Derivative Bank in a notional amount of $10 million. The CDS trades at 200 basis

points (200 basis points = 2.00 percent). In return for this credit protection, the

pension fund pays 2% of $10 million ($200,000) per annum in quarterly

installments of $50,000 to Derivative Bank.

If Risky Corporation does not default on its bond payments, the pension

fund makes quarterly payments to Derivative Bank for 5 years and receives

its $10 million back after five years from Risky Corp. Though the protection

payments totaling $1 million reduce investment returns for the pension fund,

its risk of loss due to Risky Corp defaulting on the bond is eliminated.

If Risky Corporation defaults on its debt three years into the CDS contract,

the pension fund would stop paying the quarterly premium, and Derivative

Bank would ensure that the pension fund is refunded for its loss of

$10 million minus recovery (either by physical or cash settlement - see

Settlement below). The pension fund still loses the $600,000 it has paid over

three years, but without the CDS contract it would have lost the entire

$10 million minus recovery.

In addition to financial institutions, large suppliers can use a credit default swap on

a public bond issue or a basket of similar risks as a proxy for its own credit risk

exposure on receivables.

Although credit default swaps have been highly criticized for their role in the

recent financial crisis, most observers conclude that using credit default swaps as a

hedging device has a useful purpose.

For example, if a company has announced some bad news and its share price has

dropped by 25%, but its CDS spread has remained unchanged, then an investor

might expect the CDS spread to increase relative to the share price. Therefore a

basic strategy would be to go long on the CDS spread (by buying CDS protection)

while simultaneously hedging oneself by buying the underlying stock. This

technique would benefit in the event of the CDS spread widening relative to the

equity price, but would lose money if the company's CDS spread tightened relative

to its equity.

An interesting situation in which the inverse correlation between a company's stock

price and CDS spread breaks down is during a Leveraged buyout (LBO).

Frequently this will lead to the company's CDS spread widening due to the extra

debt that will soon be put on the company's books, but also an increase in its share

price, since buyers of a company usually end up paying a premium.

Another common arbitrage strategy aims to exploit the fact that the swap-adjusted

spread of a CDS should trade closely with that of the underlying cash bond issued

by the reference entity. Misalignments in spreads may occur due to technical

reasons such as:

Specific settlement differences

Shortages in a particular underlying instrument

Existence of buyers constrained from buying exotic derivatives.

The difference between CDS spreads and asset swap spreads is called the basis and

should theoretically be close to zero. Basis trades can aim to exploit any

differences to make risk-free profit.

History

Conception

Forms of credit default swaps had been in existence from at least the early

1990s,with early trades carried out by Bankers Trust in 1991. J.P. Morgan & Co. is

widely credited with creating the modern credit default swap in 1994. In that

instance, J.P. Morgan had extended a $4.8 billion credit line to Exxon, which faced

the threat of $5 billion in punitive damages for the Exxon Valdez oil spill. A team

of J.P. Morgan bankers led by Blythe Masters then sold the credit risk from the

credit line to the European Bank of Reconstruction and Development in order to

cut the reserves which J.P. Morgan was required to hold against Exxon's default,

thus improving its own balance sheet. In 1997, JPMorgan developed a proprietary

product called BISTRO (Broad Index Securitized Trust Offering) that used CDS to

clean up a bank’s balance sheet.The advantage of BISTRO was that it used

securitization to split up the credit risk into little pieces which smaller investors

found more digestible, since most investors lacked EBRD's capability to accept

$4.8 billion in credit risk all at once. BISTRO was the first example of what later

became known as synthetic collateralized debt obligations (CDOs).

Mindful of the concentration of default risk as one of the causes of the S&L crisis ,

regulators initially found CDS's ability to disperse default risk attractive.In 2000,

credit default swaps became largely exempt from regulation by both the U.S.

Securities and Exchange Commission (SEC) and the Commodity Futures Trading

Commission (CTFC). The Commodity Futures Modernization Act of 2000, which

was also responsible for the Enron loophole,specifically stated that CDSs are

neither futures nor securities and so are outside the remit of the SEC and CTFC.

Market growth

At first, banks were the dominant players in the market, as CDS were primarily

used to hedge risk in connection with its lending activities. Banks also saw an

opportunity to free up regulatory capital. By march 1998, the global market for

CDS was estimated atabout $300 billion, with JP Morgan alone accounting for

about $50billion of this.The high market share enjoyed by the banks was soon

eroded as more and more asset managers and hedge funds saw trading

opportunities in credit default swaps. By 2002, investors as speculators, rather than

banks as hedgers, dominated the market.National banks in the USA used credit

default swaps as early as 1996. In that year, the Office of the Comptroller of the

Currency measured the size of the market as tens of billions of dollars.Six years

later, by year-end 2002, the outstanding amount was over $2 trillion.Although

speculators fueled the exponential growth, other factors also played a part. An

extended market could not emerge until 1999, when ISDA standardized the

documentation for credit default swaps Also, the 1997 Asian Financial Crisis

spurred a market for CDS in emerging market sovereign debt.In addition, in 2004,

index trading began on a large scale and grew rapidly.

The market size for Credit Default Swaps more than doubled in size each year

from $3.7 trillion in 2003.By the end of 2007, the CDS market had a notional value

of $62.2 trillion.But notional amount fell during 2008 as a result of dealer

"portfolio compression" efforts (replacing offsetting redundant contracts), and by

the end of 2008 notional amount outstanding had fallen 38 percent to $38.6 trillion.

Explosive growth was not without operational headaches. On September 15, 2005,

the New York Fed summoned 14 banks to it offices. Billions of dollars of CDS

were traded daily but the record keeping was more than two weeks behind This

created severe risk management issues, as counterparties were in legal and

financial limbo U.K. authorities expressed the same concerns.

Market as of 2008

Composition of the United States 15.5 trillion US dollar CDS market at the end of

2008 Q2. Green tints show Prime asset CDSs, reddish tints show sub-prime asset

CDSs. Numbers followed by "Y" indicate years until maturity.

Proportion of CDSs nominals (lower left) held by United States banks compared to

all derivatives, in 2008Q2. The black disc represents the 2008 public debt.

Since default is a relatively rare occurrence (historically around 0.2% of

investment grade companies will default in any one year), in most CDS contracts

the only payments are the premium payments from buyer to seller. Thus, although

the above figures for outstanding notionals are very large, in the absence of default

the net cashflows will only be a small fraction of this total: for a 100 bp = 1%

spread, the annual cash flows are only 1% of the notional amount.

Regulatory concerns over CDS

The market for Credit Default Swaps attracted considerable concern from

regulators after a number of large scale incidents in 2008, starting with the collapse

of Bear Stearns.

In the days and weeks leading up to Bear's collapse, the bank's CDS spread

widened dramatically, indicating a surge of buyers taking out protection on the

bank. It has been suggested that this widening was responsible for the perception

that Bear Stearns was vulnerable, and therefore restricted its access to wholesale

capital which eventually led to its forced sale to JP Morgan in March. An

alternative, unsupported view is that this surge in CDS protection buyers was a

symptom rather than a cause of Bear's collapse; i.e., investors saw that Bear was in

trouble, and sought to hedge any naked exposure to the bank, or speculate on its

collapse.

In September, the bankruptcy of Lehman Brothers caused a total close to

$400 billion to become payable to the buyers of CDS protection referenced against

the insolvent bank. However the net amount that changed hands was around

$7.2 billion This difference is due to the process of 'netting'. Market participants

co-operated so that CDS sellers were allowed to deduct from their payouts the

inbound funds due to them from their hedging positions. Dealers generally attempt

to remain risk-neutral so their losses and gains after big events will on the whole

offset each other.

Also in September American International Group (AIG) required a federal bailout

because it had been excessively selling CDS protection without hedging against the

possibility that the reference entities might decline in value, which exposed the

insurance giant to potential losses over $100 billion. The CDS on Lehman were

settled smoothly, as was largely the case for the other 11 credit events occurring in

2008 which triggered payouts.And while it is arguable that other incidents would

have been as bad or worse if less efficient instruments than CDS had been used for

speculation and insurance purposes, the closing months of 2008 saw regulators

working hard to reduce the risk involved in CDS transactions.

In 2008 there was no centralized exchange or clearing house for CDS transactions;

they were all done over the counter (OTC). This led to recent calls for the market

to open up in terms of transparency and regulation.In November, DTCC, which

runs a warehouse for CDS trade confirmations accounting for around 90% of the

total market,announced that it will release market data on the outstanding notional

of CDS trades on a weekly basis.The data can be accessed on the DTCC's website

here:The U.S. Securities and Exchange Commission granted an exemption for

IntercontinentalExchange to begin guaranteeing credit-default swaps.

The SEC exemption represented the last regulatory approval needed by Atlanta-

based Intercontinental. Its larger competitor, CME Group Inc., hasn’t received an

SEC exemption, and agency spokesman John Nester said he didn’t know when a

decision would be made.

Market as of 2009

The early months of 2009 saw several fundamental changes to the way CDSs

operate, resulting from concerns over the instruments' safety after the events of the

previous year. According to Deutsche Bank managing director Athanassios Diplas

"the industry pushed through 10 years worth of changes in just a few months" By

late 2008 processes had been introduced allowing CDSs which offset each other to

be cancelled. Along with termination of contracts that have recently paid out such

as those based on Lehmans, this had by March reduced the face value of the

market down to an estimated $30 trillion.The Bank for International Settlements

estimates that outstanding derivatives total $592 trillion.U.S. and European

regulators are developing separate plans to stabilize the derivatives market.

Additionally there are some globally agreed standards falling into place in March

2009, administered by International Swaps and Derivatives Association (ISDA).

Two of the key changes are:

1. The introduction of central clearing houses, one for the US and one for Europe.

A clearing house acts as the central counterparty to both sides of a CDS

transaction, thereby reducing the counterparty risk that both buyer and seller face.

2. The international standardization of CDS contracts, to prevent legal disputes in

ambiguous cases where what the payout should be is unclear.

In the U.S., central clearing operations began in March 2009 , operated by

InterContinental Exchange (ICE). A key competitor also interested in entering the

CDS clearing sector is CME Group.

In Europe, CDS Index clearing was launched by ICE's European subsidiary ICE

Clear Europe on July 31. It launched Single Name clearing in Dec 2009. By the

end of 2009, it had cleared CDS contracts worth EUR 885 billion reducing the

open interest down to EUR 75 billion.

By the end of 2009, banks had reclaimned much of their market share; hedge funds

had largely retreated from the market after the crises. According to an estimate by

the Banque de France, by late 2009 the bank JP Morgan alone now had about 30%

of the global CDS market.

Government approvals relating to Intercontinental and its competitor CME

The SEC's approval for ICE's request to be exempted from rules that would

prevent it clearing CDSs was the third government action granted to

Intercontinental in one week. On March 3, its proposed acquisition of Clearing

Corp., a Chicago clearinghouse owned by eight of the largest dealers in the credit-

default swap market, was approved by the Federal Trade Commission and the

Justice Department. On March 5, the Federal Reserve Board, which oversees the

clearinghouse, granted a request for ICE to begin clearing.

Clearing Corp. shareholders including JPMorgan Chase & Co., Goldman Sachs

Group Inc. and UBS AG, received $39 million in cash from Intercontinental in the

acquisition, as well as the Clearing Corp.’s cash on hand and a 50-50 profit-sharing

agreement with Intercontinental on the revenue generated from processing the

swaps.

SEC spokesperson John Nestor stated

“ For several months the SEC and our fellow regulators have worked closely

with all of the firms wishing to establish central counterparties.... We

believe that CME should be in a position soon to provide us with the

information necessary to allow the commission to take action on its

exemptive requests. ”

Other proposals to clear credit-default swaps have been made by NYSE Euronext,

Eurex AG and LCH.Clearnet Ltd. Only the NYSE effort is available now for

clearing after starting on Dec. 22. As of Jan. 30, no swaps had been cleared by the

NYSE’s London- based derivatives exchange, according to NYSE Chief Executive

Officer Duncan Niederauer.

Clearing house member requirements

Members of the Intercontinental clearinghouse will have to have a net worth of at

least $5 billion and a credit rating of A or better to clear their credit-default swap

trades. Intercontinental said in the statement today that all market participants such

as hedge funds, banks or other institutions are open to become members of the

clearinghouse as long as they meet these requirements.

A clearinghouse acts as the buyer to every seller and seller to every buyer,

reducing the risk of a counterparty defaulting on a transaction. In the over-the-

counter market, where credit- default swaps are currently traded, participants are

exposed to each other in case of a default. A clearinghouse also provides one

location for regulators to view traders’ positions and prices.

Terms of a typical CDS contract

A CDS contract is typically documented under a confirmation referencing the

credit derivatives definitions as published by the International Swaps and

Derivatives Association.The confirmation typically specifies a reference entity, a

corporation or sovereign that generally, although not always, has debt outstanding,

and a reference obligation, usually an unsubordinated corporate bond or

government bond. The period over which default protection extends is defined by

the contract effective date and scheduled termination date.

The confirmation also specifies a calculation agent who is responsible for making

determinations as to successors and substitute reference obligations (for example

necessary if the original reference obligation was a loan that is repaid before the

expiry of the contract), and for performing various calculation and administrative

functions in connection with the transaction. By market convention, in contracts

between CDS dealers and end-users, the dealer is generally the calculation agent,

and in contracts between CDS dealers, the protection seller is generally the

calculation agent. It is not the responsibility of the calculation agent to determine

whether or not a credit event has occurred but rather a matter of fact that, pursuant

to the terms of typical contracts, must be supported by publicly available

information delivered along with a credit event notice. Typical CDS contracts do

not provide an internal mechanism for challenging the occurrence or non-

occurrence of a credit event and rather leave the matter to the courts if necessary,

though actual instances of specific events being disputed are relatively rare.

CDS confirmations also specify the credit events that will give rise to payment

obligations by the protection seller and delivery obligations by the protection

buyer. Typical credit events include bankruptcy with respect to the reference entity

and failure to pay with respect to its direct or guaranteed bond or loan debt. CDS

written on North American investment grade corporate reference entities,

European corporate reference entities and sovereigns generally also include

restructuring as a credit event, whereas trades referencing North American high

yield corporate reference entities typically do not. The definition of restructuring is

quite technical but is essentially intended to respond to circumstances where a

reference entity, as a result of the deterioration of its credit, negotiates changes in

the terms in its debt with its creditors as an alternative to formal insolvency

proceedings (i.e., the debt is restructured). This practice is far more typical in

jurisdictions that do not provide protective status to insolvent debtors similar to

that provided by Chapter 11 of the United States Bankruptcy Code. In particular,

concerns arising out of Conseco's restructuring in 2000 led to the credit event's

removal from North American high yield trades.

Finally, standard CDS contracts specify deliverable obligation characteristics that

limit the range of obligations that a protection buyer may deliver upon a credit

event. Trading conventions for deliverable obligation characteristics vary for

different markets and CDS contract types. Typical limitations include that

deliverable debt be a bond or loan, that it have a maximum maturity of 30 years,

that it not be subordinated, that it not be subject to transfer restrictions (other than

Rule 144A), that it be of a standard currency and that it not be subject to some

contingency before becoming due.

The premium payments are generally quarterly, with maturity dates (and likewise

premium payment dates) falling on March 20, June 20, September 20, and

December 20. Due to the proximity to the IMM dates, which fall on the third

Wednesday of these months, these CDS maturity dates are also referred to as

"IMM dates".

Settlement

Physical or cash

As described in an earlier section, if a credit event occurs then CDS contracts can

either be physically settled or cash settled.

Physical settlement: The protection seller pays the buyer par value, and in

return takes delivery of a debt obligation of the reference entity. For

example, a hedge fund has bought $5 million worth of protection from a

bank on the senior debt of a company. In the event of a default, the bank will

pay the hedge fund $5 million cash, and the hedge fund must deliver

$5 million face value of senior debt of the company (typically bonds or

loans, which will typically be worth very little given that the company is in

default).

Cash settlement: The protection seller pays the buyer the difference between

par value and the market price of a debt obligation of the reference entity.

For example, a hedge fund has bought $5 million worth of protection from a

bank on the senior debt of a company. This company has now defaulted, and

its senior bonds are now trading at 25 (i.e. 25 cents on the dollar) since the

market believes that senior bondholders will receive 25% of the money they

are owed once the company is wound up. Therefore, the bank must pay the

hedge fund $5 million * (100%-25%) = $3.75 million.

The development and growth of the CDS market has meant that on many

companies there is now a much larger outstanding notional of CDS contracts than

the outstanding notional value of its debt obligations. (This is because many parties

made CDS contracts for speculative purposes, without actually owning any debt

for which they wanted to insure against default.) For example, at the time it filed

for bankruptcy on September 14, 2008, Lehman Brothers had approximately

$155 billion of outstanding debt but around $400 billion notional value of CDS

contracts had been written which referenced this debt. Clearly not all of these

contracts could be physically settled, since there was not enough outstanding

Lehman Brothers debt to fulfill all of the contracts, demonstrating the necessity for

cash settled CDS trades. The trade confirmation produced when a CDS is traded

will state whether the contract is to be physically or cash settled.

Auctions

When a credit event occurs on a major company on which a lot of CDS contracts

are written, an auction (also known as a credit-fixing event) may be held to

facilitate settlement of a large number of contracts at once, at a fixed cash

settlement price. During the auction process participating dealers (e.g., the big

investment banks) submit prices at which they would buy and sell the reference

entity's debt obligations, as well as net requests for physical settlement against par.

A second stage Dutch auction is held following the publication of the initial mid-

point of the dealer markets and what is the net open interest to deliver or be

delivered actual bonds or loans. The final clearing point of this auction sets the

final price for cash settlement of all CDS contracts and all physical settlement

requests as well as matched limit offers resulting from the auction are actually

settled. According to the International Swaps and Derivatives Association (ISDA),

who organised them, auctions have recently proved an effective way of settling the

very large volume of outstanding CDS contracts written on companies such as

Lehman Brothers and Washington Mutual.

Below is a list of the auctions that have been held since 2005.

Date NameFinal price as a percentage of

par

2005-06-

14Collins & Aikman - Senior 43.625

2005-06-

23Collins & Aikman - Subordinated 6.375

2005-10- Northwest Airlines 28

11

2005-10-

11Delta Airlines 18

2005-11-

04Delphi Corporation 63.375

2006-01-

17Calpine Corporation 19.125

2006-03-

31Dana Corporation 75

2006-11-

28Dura - Senior 24.125

2006-11-

28Dura - Subordinated 3.5

2007-10-

23Movie Gallery 91.5

2008-02-

19Quebecor World 41.25

2008-10-

02Tembec Inc 83

2008-10-

06Fannie Mae - Senior 91.51

2008-10- Fannie Mae - Subordinated 99.9

06

2008-10-

06Freddie Mac - Senior 94

2008-10-

06Freddie Mac - Subordinated 98

2008-10-

10Lehman Brothers 8.625

2008-10-

23Washington Mutual 57

2008-11-

04Landsbanki - Senior 1.25

2008-11-

04Landsbanki - Subordinated 0.125

2008-11-

05Glitnir - Senior 3

2008-11-

05Glitnir - Subordinated 0.125

2008-11-

06Kaupthing - Senior 6.625

2008-11-

06Kaupthing - Subordinated 2.375

2008-12- Masonite [7] - LCDS 52.5

09

2008-12-

17Hawaiian Telcom - LCDS 40.125

2009-01-

06Tribune - CDS 1.5

2009-01-

06Tribune - LCDS 23.75

2009-01-

14Republic of Ecuador 31.375

2009-02-

03Millennium America Inc 7.125

2009-02-

03Lyondell - CDS 15.5

2009-02-

03Lyondell - LCDS 20.75

2009-02-

03EquiStar 27.5

2009-02-

05Sanitec [8] - 1st Lien 33.5

2009-02-

05Sanitec [9] - 2nd Lien 4.0

2009-02- British Vita [10] - 1st Lien 15.5

09

2009-02-

09British Vita [11] - 2nd Lien 2.875

2009-02-

10Nortel Ltd. 6.5

2009-02-

10Nortel Corporation 12

2009-02-

19Smurfit-Stone CDS 8.875

2009-02-

19Smurfit-Stone LCDS 65.375

2009-02-

26Ferretti 10.875

2009-03-

09Aleris 8

2009-03-

31Station Casinos 32

2009-04-

14Chemtura 15

2009-04-

14Great Lakes 18.25

2009-04- Rouse 29.25

15

2009-04-

16LyondellBasell 2

2009-04-

17Abitibi 3.25

2009-04-

21Charter Communications CDS 2.375

2009-04-

21Charter Communications LCDS 78

2009-04-

22Capmark 23.375

2009-04-

23Idearc CDS 1.75

2009-04-

23Idearc LCDS 38.5

2009-05-

12Bowater 15

2009-05-

13General Growth Properties 44.25

2009-05-

27Syncora 15

2009-05- Edshcha 3.75

28

2009-06-

09HLI Operating Corp LCDS 9.5

2009-06-

10Georgia Gulf LCDS 83

2009-06-

11R.H. Donnelley Corp. CDS 4.875

2009-06-

12General Motors CDS 12.5

2009-06-

12General Motors LCDS 97.5

2009-06-

18JSC Alliance Bank CDS 16.75

2009-06-

23Visteon CDS 3

2009-06-

23Visteon LCDS 39

2009-06-

24RH Donnelley Inc LCDS 78.125

2009-07-

09Six Flags CDS 14

2009-07- Six Flags LCDS 96.125

09

2009-07-

21Lear CDS 38.5

2009-07-

21Lear LCDS 66

2009-11-

10

METRO-GOLDWYN-MAYER INC.

LCDS58.5

2009-11-

20CIT Group Inc. 68.125

Pricing and valuation

There are two competing theories usually advanced for the pricing of credit default

swaps. The first, referred to herein as the 'probability model', takes the present

value of a series of cashflows weighted by their probability of non-default. This

method suggests that credit default swaps should trade at a considerably lower

spread than corporate bonds.

The second model, proposed by Darrell Duffie, but also by John Hull and White,

uses a no-arbitrage approach.

[edit] Probability model

Under the probability model, a credit default swap is priced using a model that

takes four inputs; this is similar to the rNPV (risk-adjusted NPV) model used in

drug development:

the "issue premium",

the recovery rate (percentage of notional repaid in event of default),

the "credit curve" for the reference entity and

the "LIBOR curve".

If default events never occurred the price of a CDS would simply be the sum of the

discounted premium payments. So CDS pricing models have to take into account

the possibility of a default occurring some time between the effective date and

maturity date of the CDS contract. For the purpose of explanation we can imagine

the case of a one year CDS with effective date t0 with four quarterly premium

payments occurring at times t1, t2, t3, and t4. If the nominal for the CDS is N and the

issue premium is c then the size of the quarterly premium payments is Nc / 4. If we

assume for simplicity that defaults can only occur on one of the payment dates then

there are five ways the contract could end:

either it does not have any default at all, so the four premium payments are

made and the contract survives until the maturity date, or

a default occurs on the first, second, third or fourth payment date.

To price the CDS we now need to assign probabilities to the five possible

outcomes, then calculate the present value of the payoff for each outcome. The

present value of the CDS is then simply the present value of the five payoffs

multiplied by their probability of occurring.

This is illustrated in the following tree diagram where at each payment date either

the contract has a default event, in which case it ends with a payment of N(1 − R)

shown in red, where R is the recovery rate, or it survives without a default being

triggered, in which case a premium payment of Nc / 4 is made, shown in blue. At

either side of the diagram are the cashflows up to that point in time with premium

payments in blue and default payments in red. If the contract is terminated the

square is shown with solid shading.

The probability of surviving over the interval ti − 1 to ti without a default payment is

pi and the probability of a default being triggered is 1 − pi. The calculation of

present value, given discount factor of δ1 to δ4 is then

Description Premium Payment PVDefault Payment

PVProbability

Default at time

t1

Default at time

t2

Default at time

t3

Default at time

t4

No defaults

The probabilities p1, p2, p3, p4 can be calculated using the credit spread curve. The

probability of no default occurring over a time period from t to t + Δt decays

exponentially with a time-constant determined by the credit spread, or

mathematically p = exp( − s(t)Δt / (1 − R)) where s(t) is the credit spread zero

curve at time t. The riskier the reference entity the greater the spread and the more

rapidly the survival probability decays with time.

To get the total present value of the credit default swap we multiply the probability

of each outcome by its present value to give

No-arbitrage model

In the 'no-arbitrage' model proposed by both Duffie, and Hull-White, it is assumed

that there is no risk free arbitrage. Duffie uses the LIBOR as the risk free rate,

whereas Hull and White use US Treasuries as the risk free rate. Both analyses

make simplifying assumptions (such as the assumption that there is zero cost of

unwinding the fixed leg of the swap on default), which may invalidate the no-

arbitrage assumption. However the Duffie approach is frequently used by the

market to determine theoretical prices. Under the Duffie construct, the price of a

credit default swap can also be derived by calculating the asset swap spread of a

bond. If a bond has a spread of 100, and the swap spread is 70 basis points, then a

CDS contract should trade at 30. However there are sometimes technical reasons

why this will not be the case, and this may or may not present an arbitrage

opportunity for the canny investor. The difference between the theoretical model

and the actual price of a credit default swap is known as the basis.

Criticisms

Critics of the huge credit default swap market have claimed that it has been

allowed to become too large without proper regulation and that, because all

contracts are privately negotiated, the market has no transparency. Furthermore,

there have even been claims that CDSs exacerbated the 2008 global financial crisis

by hastening the demise of companies such as Lehman Brothers and AIG.[70]

In the case of Lehman Brothers, it is claimed that the widening of the bank's CDS

spread reduced confidence in the bank and ultimately gave it further problems that

it was not able to overcome. However, proponents of the CDS market argue that

this confuses cause and effect; CDS spreads simply reflected the reality that the

company was in serious trouble. Furthermore, they claim that the CDS market

allowed investors who had counterparty risk with Lehman Brothers to reduce their

exposure in the case of their default.

Credit default swaps have also faced criticism that they contributed to a breakdown

in negotiations during the GM bankruptcy, because bondholders would benefit

from the credit event of a GM bankruptcy due to their holding of CDSs. Critics

speculate that these creditors were incentivized into pushing for the company to

enter bankruptcy protection.[71] Due to a lack of transparency, there was no way to

find out who the protection buyers and protection writers were, and they were

subsequently left out of the negotiation process.[72]

It was also reported after Lehman's bankruptcy that the $400 billion notional of

CDS protection which had been written on the bank could lead to a net payout of

$366 billion from protection sellers to buyers (given the cash-settlement auction

settled at a final price of 8.625%) and that these large payouts could lead to further

bankruptcies of firms without enough cash to settle their contracts. [73] However,

industry estimates after the auction suggested that net cashflows would only be in

the region of $7 billion.[73] This is because many parties held offsetting positions;

for example if a bank writes CDS protection on a company it is likely to then enter

an offsetting transaction by buying protection on the same company in order to

hedge its risk. Furthermore, CDS deals are marked-to-market frequently. This

would have led to margin calls from buyers to sellers as Lehman's CDS spread

widened, meaning that the net cashflows on the days after the auction are likely to

have been even lower.[68]... Senior bankers have argued that not only has the CDS

market functioned remarkably well during the financial crisis, but that CDS

contracts have been acting to distribute risk just as was intended, and that it is not

CDSs themselves that need further regulation, but the parties who trade them.[74]

Some general criticism of financial derivatives is also relevant to credit derivatives.

Warren Buffett famously described derivatives bought speculatively as "financial

weapons of mass destruction." In Berkshire Hathaway's annual report to

shareholders in 2002, he said, "Unless derivatives contracts are collateralized or

guaranteed, their ultimate value also depends on the creditworthiness of the

counterparties to them. In the meantime, though, before a contract is settled, the

counterparties record profits and losses—often huge in amount—in their current

earnings statements without so much as a penny changing hands. The range of

derivatives contracts is limited only by the imagination of man (or sometimes, so it

seems, madmen)."[75] To hedge the counterparty risk of entering a CDS transaction,

one practice is to buy CDS protection on one's counterparty. The positions are

marked-to-market daily and collateral pass from buyer to seller or vice versa to

protect both parties against counterparty default, but money does not always

change hands due to the offset of gains and losses by those who had both bought

and sold protection. Depository Trust & Clearing Corporation, the clearinghouse

for the majority of trades in the US over-the-counter market, stated in October

2008 that once offsetting trades were considered, only an estimated $6 billion

would change hands on October 21, during the settlement of the CDS contracts

issued on Lehman Brothers' debt, which amounted to somewhere between $150 to

$360 billion.[76] Despite Buffett's criticism on derivatives, in October 2008

Berkshire Hathaway revealed to regulators that it has entered into at least

$4.85 billion in derivative transactions.[77] Buffett stated in his 2008 letter to

shareholders that Berkshire Hathaway has no counterparty risk in its derivative

dealings because Berkshire require counterparties to make payments when

contracts are inititated, so that Berkshire always holds the money.[78] Berkshire

Hathaway was a large owner of Moody's stock during the period that it was one of

two primary rating agencies for subprime CDOs, a form of mortgage security

derivative dependant on the use of credit default swaps.

The monoline insurance companies got involved with writing credit default swaps

on mortgage-backed CDOs. Some media reports have claimed this was a

contributing factor to the downfall of some of the monolines.[79][80] In 2009 one of

the monolines, MBIA, sued Merrill Lynch, claiming that Merill had

misrepresented some of its CDOs to MBIA in order to persuade MBIA to write

CDS protection for those CDOs.[81][82][83]

[edit] Systemic risk

The risk of counterparties defaulting has been amplified during the 2008 financial

crisis, particularly because Lehman Brothers and AIG were counterparties in a

very large number of CDS transactions. This is an example of systemic risk, risk

which threatens an entire market, and a number of commentators have argued that

size and deregulation of the CDS market have increased this risk.

For example, imagine if a hypothetical mutual fund had bought some Washington

Mutual corporate bonds in 2005 and decided to hedge their exposure by buying

CDS protection from Lehman Brothers. After Lehman's default, this protection

was no longer active, and Washington Mutual's sudden default only days later

would have led to a massive loss on the bonds, a loss that should have been insured

by the CDS. There was also fear that Lehman Brothers and AIG's inability to pay

out on CDS contracts would lead to the unraveling of complex interlinked chain of

CDS transactions between financial institutions.[84] So far this does not appear to

have happened, although some commentators[who?] have noted that because the total

CDS exposure of a bank is not public knowledge, the fear that one could face large

losses or possibly even default themselves was a contributing factor to the massive

decrease in lending liquidity during September/October 2008.[85]

Chains of CDS transactions can arise from a practice known as "netting".[86] Here,

company B may buy a CDS from company A with a certain annual "premium", say

2%. If the condition of the reference company worsens, the risk premium will rise,

so company B can sell a CDS to company C with a premium of say, 5%, and

pocket the 3% difference. However, if the reference company defaults, company B

might not have the assets on hand to make good on the contract. It depends on its

contract with company A to provide a large payout, which it then passes along to

company C. The problem lies if one of the companies in the chain fails, creating a

"domino effect" of losses. For example, if company A fails, company B will

default on its CDS contract to company C, possibly resulting in bankruptcy, and

company C will potentially experience a large loss due to the failure to receive

compensation for the bad debt it held from the reference company. Even worse,

because CDS contracts are private, company C will not know that its fate is tied to

company A; it is only doing business with company B.

As described above, the establishment of a central exchange or clearing house for

CDS trades would help to solve the "domino effect" problem, since it would mean

that all trades faced a central counterparty guaranteed by a consortium of dealers.

[edit] Tax and accounting issues

The U.S federal income tax treatment of credit default swaps is uncertain.[87]

Commentators generally believe that, depending on how they are drafted, they are

either notional principal contracts or options for tax purposes,[88] but this is not

certain. There is a risk of having credit default swaps recharacterized as different

types of financial instruments because they resemble put options and credit

guarantees. In particular, the degree of risk depends on the type of settlement

(physical/cash and binary/FMV) and trigger (default only/any credit event).[89] If a

credit default swap is a notional principal contract, periodic and nonperiodic

payments on the swap are deductible and included in ordinary income. [90] If a

payment is a termination payment, its tax treatment is even more uncertain.[90] In

2004, the Internal Revenue Service announced that it was studying the

characterization of credit default swaps in response to taxpayer confusion,[91] but it

has not yet issued any guidance on their characterization. A taxpayer must include

income from credit default swaps in ordinary income if the swaps are connected

with trade or business in the United States.[92]

The accounting treatment of Credit Default Swaps used for hedging may not

parallel the economic effects and instead, increase volatility. For example, GAAP

generally require that Credit Default Swaps be reported on a mark to market basis.

In contrast, assets that are held for investment, such as a commercial loan or bonds,

are reported at cost, unless a probable and significant loss is expected. Thus,

hedging a commercial loan using a CDS can induce considerable volatility into the

income statement and balance sheet as the CDS changes value over its life due to

market conditions and due to the tendency for shorter dated CDS to sell at lower

prices than longer dated CDS. One can try to account for the CDS as a hedge under

FASB 133[93] but in practice that can prove very difficult unless the risky asset

owned by the bank or corporation is exactly the same as the Reference Obligation

used for the particular CDS that was bought.

Recovery swap

In finance, recovery swaps, recovery locks, or recovery default swaps (RDS)

are derivative contracts related to credit default swaps, and reference a bond

issuance as its underlying. They are designed to provide a hedge against the

uncertainty of recovery in default.

The International Swaps and Derivatives Association does not keep records on the

size of the recovery swap market because there has not yet been sufficient member

demand.[1]

Terms

A recovery swap is an agreement between two parties to swap a real recovery rate

(whenever it is ascertained) with a fixed recovery rate that can be locked in today.

The parties are speculating on whether a company that is no longer liquid will pay

out more or less than a certain percentage for each bond. The reference price is set

to the fixed recovery rate rather than 100, chosen such that the RDS prices at zero

on issue. Since the swap is issued at a price of zero, if the reference entity does not

default in the term of the swap, then the swap expires with no cashflows having

taken place.

Because the swap only has value (to either counterparty) during a default, the main

market in RDS involves bonds that pose a high risk of default, when the reference

entity (company) is in financial difficulty.

Connection to fixed recovery CDS

A related instrument is a fixed recovery CDS. In theory an RDS protection (receive

fixed recovery) can be approximated by buying protection with fixed CDS (binary

CDS) and selling the ordinary CDS (writing protection). In reality there may be a

slight difference in the terms of the swaps, particularly relating to settlement. It is

usually the case that fixed recovery CDS are settled immediately, since there is no

need to wait for recovery to be determined, whereas a recovery swap will wait until

the ordinary CDS is settled before paying out.

Currency swap

A currency swap is a foreign-exchange agreement between two parties to

exchange aspects (namely the principal and/or interest payments) of a loan in one

currency for equivalent aspects of an equal in net present value loan in another

currency; see Foreign exchange derivative. Currency swaps are motivated by

comparative advantage.[1] A currency swap should be distinguished from a central

bank liquidity swap

Structure

Currency swaps are over-the-counter derivatives, and are closely related to interest

rate swaps. However, unlike interest rate swaps, currency swaps can involve the

exchange of the principal.[1]

There are three different ways in which currency swaps can exchange loans:

The most simple currency swap structure is to exchange the principal only with the

counterparty, at a rate agreed now, at some specified point in the future. Such an

agreement performs a function equivalent to a forward contract or futures. The cost

of finding a counterparty (either directly or through an intermediary), and drawing

up an agreement with them, makes swaps more expensive than alternative

derivatives (and thus rarely used) as a method to fix shorter term forward exchange

rates. However for the longer term future, commonly up to 10 years, where spreads

are wider for alternative derivatives, principal-only currency swaps are often used

as a cost-effective way to fix forward rates. This type of currency swap is also

known as an FX-swap.[2]

Another currency swap structure is to combine the exchange of loan principal, as

above, with an interest rate swap. In such a swap, interest cash flows are not netted

before they are paid to the counterparty (as they would be in a vanilla interest rate

swap) because they are denominated in different currencies. As each party

effectively borrows on the other's behalf, this type of swap is also known as a

back-to-back loan.[2]

Last here, but certainly not least important, is to swap only interest payment cash

flows on loans of the same size and term. Again, as this is a currency swap, the

exchanged cash flows are in different denominations and so are not netted. An

example of such a swap is the exchange of fixed-rate US Dollar interest payments

for floating-rate interest payments in Euro. This type of swap is also known as a

cross-currency interest rate swap, or cross-currency swap.[3]

Uses

Currency swaps have two main uses:

To secure cheaper debt (by borrowing at the best available rate regardless of

currency and then swapping for debt in desired currency using a back-to-

back-loan).[2]

To hedge against (reduce exposure to) exchange rate fluctuations.[2]

[edit] Hedging Example

For instance, a US-based company needing to borrow Swiss Francs, and a Swiss-

based company needing to borrow a similar present value in US Dollars, could

both reduce their exposure to exchange rate fluctuations by arranging any one of

the following:

If the companies have already borrowed in the currencies each needs the

principal in, then exposure is reduced by swapping cash flows only, so that

each company's finance cost is in that company's domestic currency.

Alternatively, the companies could borrow in their own domestic currencies

(and may well each have comparative advantage when doing so), and then

get the principal in the currency they desire with a principal-only swap.

History

Currency swaps were originally conceived in the 1970s to circumvent foreign

exchange controls in the United Kingdom. At that time, UK companies had to pay

a premium to borrow in US Dollars. To avoid this, UK companies set up back-to-

back loan agreements with US companies wishing to borrow Sterling.[4] While

such restrictions on currency exchange have since become rare, savings are still

available from back-to-back loans due to comparative advantage.

Cross-currency interest rate swaps were introduced by the World Bank in 1981 to

obtain Swiss francs and German marks by exchanging cash flows with IBM. This

deal was brokered by Salomon Brothers with a notional amount of $210 million

dollars and a term of over ten years.[5]

During the global financial crisis of 2008, the currency swap transaction structure

was used by the United States Federal Reserve System to establish central bank

liquidity swaps. In these, the Federal Reserve and the central bank of a developed[6]

or stable emerging[7] economy agree to exchange domestic currencies at the current

prevailing market exchange rate & agree to reverse the swap at the same exchange

rate at a fixed future date. The aim of central bank liquidity swaps is "to provide

liquidity in U.S. dollars to overseas markets."[8] While central bank liquidity swaps

and currency swaps are structurally the same, currency swaps are commercial

transactions driven by comparative advantage, while central bank liquidity swaps

are emergency loans of US Dollars to overseas markets, and it is currently

unknown whether or not they will be beneficial for the Dollar or the US in the

long-term.[9]

The People's Republic of China has multiple year currency swap agreements of the

Renminbi with Argentina, Belarus, Hong Kong, Iceland, Indonesia, Malaysia,

Singapore, and South Korea that perform a similar function to central bank

liquidity swaps.[10]

How Does a Currency Swap Work?

A currency swap agreement specifies the principal amount to be swapped, a

common maturity period and the interest and exchange rates determined at the

commencement of the contract. The two parties would continue to exchange the

interest payment at the predetermined rate until the maturity period is reached. On

the date of maturity, the two parties swap the principal amount specified in the

contract.

The equivalent amount of the loan value in another currency is calculated by using

the net present value (NPV). This implies that the exchange of the principal

amount is carried out at market rates during the inception and maturity periods of

the agreement.

Benefits of Currency Swaps

The benefits of currency swaps are:

Help portfolio managers regulate their exposure to interest rates.

Speculators can benefit from a favorable change in interest rates.

Reduce uncertainty associated with future cash flows as it enables companies to

modify their debt conditions.

Reduce costs and risks associated with currency exchange.

Companies having fixed rate liabilities can capitalize on floating-rate swaps and

vise versa, based on the prevailing economic scenario.

Limitations of Currency Swaps

The drawbacks of currency swaps are:

Exposed to credit risk as either one or both the parties could default on interest

and principal payments.

Vulnerable to the central government’s intervention in the exchange markets.

This happens when the government of a country acquires huge foreign debts to

temporarily support a declining currency. This leads to a huge downturn in the

value of the domestic currency.

Who would use a swap?

The motivations for using swap contracts fall into two basic categories:

commercial needs and comparative advantage. The normal business operations of

some firms lead to certain types of interest rate or currency exposures that swaps

can alleviate. For example, consider a bank, which pays a floating rate of interest

on deposits (i.e., liabilities) and earns a fixed rate of interest on loans (i.e., assets).

This mismatch between assets and liabilities can cause tremendous difficulties. The

bank could use a fixed-pay swap (pay a fixed rate and receive a floating rate) to

convert its fixed-rate assets into floating-rate assets, which would match up well

with its floating-rate liabilities. 

Some companies have a comparative advantage in acquiring certain types of

financing. However, this comparative advantage may not be for the type of

financing desired. In this case, the company may acquire the financing for which it

has a comparative advantage, then use a swap to convert it to the desired type of

financing.

For example, consider a well-known U.S. firm that wants to expand its operations

into Europe, where it is less well known. It will likely receive more favorable

financing terms in the US. By then using a currency swap, the firm ends with the

euros it needs to fund its expansion.

Exiting a Swap Agreement

Sometimes one of the swap parties needs to exit the swap prior to the agreed-upon

termination date. This is similar to an investor selling an exchange-traded futures

or option contract before expiration. There are four basic ways to do this.

1. Buy Out the Counterparty

Just like an option or futures contract, a swap has a calculable market value,

so one party may terminate the contract by paying the other this market

value. However, this is not an automatic feature, so either it must be

specified in the swaps contract in advance, or the party who wants out must

secure the counterparty's consent.

2. Enter an Offsetting Swap

For example, Company A from the interest rate swap example above could

enter into a second swap, this time receiving a fixed rate and paying a

floating rate.

3. Sell the Swap to Someone Else 

Because swaps have calculable value, one party may sell the contract to a

third party. As with Strategy 1, this requires the permission of the

counterparty. 

4. Use a Swaption 

A swaption is an option on a swap. Purchasing a swaption would allow a

party to set up, but not enter into, a potentially offsetting swap at the time

they execute the original swap. This would reduce some of the market risks

associated with Strategy 2..

Equity swap

An equity swap is a financial derivative contract (a swap) where a set of future

cash flows are agreed to be exchanged between two counterparties at set dates in

the future. The two cash flows are usually referred to as "legs" of the swap; one of

these "legs" is usually pegged to a floating rate such as LIBOR. This leg is also

commonly referred to as the "floating leg". The other leg of the swap is based on

the performance of either a share of stock or a stock market index. This leg is

commonly referred to as the "equity leg". Most equity swaps involve a floating leg

vs. an equity leg, although some exist with two equity legs.

An equity swap involves a notional principal, a specified tenor and predetermined

payment intervals.

Equity swaps are typically traded by Delta One trading desks.

Examples

Parties may agree to make periodic payments or a single payment at the maturity

of the swap ("bullet" swap), the worst case.

Take a simple index swap where Party A swaps £5,000,000 at LIBOR + 0.03%

(also called LIBOR + 3 basis points) against £5,000,000 (FTSE to the £5,000,000

notional). In this case Party A will pay (to Party B) a floating interest rate (LIBOR

+0.03%) on the £5,000,000 notional and would receive from Party B any

percentage increase in the FTSE equity index applied to the £5,000,000 notional.

In this example, assuming a LIBOR rate of 5.97% p.a. and a swap tenor of

precisely 180 days, the floating leg payer/equity receiver (Party A) would owe

(5.97%+0.03%)*£5,000,000*180/360 = £150,000 to the equity payer/floating leg

receiver (Party B).

At the same date (after 180 days) if the FTSE had appreciated by 10% from its

level at trade commencement, Party B would owe 10%*£5,000,000 = £500,000 to

Party A. If, on the other hand, the FTSE at the six-month mark had fallen by 10%

from its level at trade commencement, Party A would owe an additional

10%*£5,000,000 = £500,000 to Party B, since the flow is negative.

For mitigating credit exposure, the trade can be reset, or "marked-to-market"

during its life. In that case, appreciation or depreciation since the last reset is paid

and the notional is increased by any payment to the pricing rate payer or decreased

by any payment from the floating leg payer.

Applications

Typically Equity Swaps are entered into in order to avoid transaction costs

(including Tax), to avoid locally based dividend taxes, limitations on leverage

(notably the US margin regime) or to get around rules governing the particular type

of investment that an institution can hold.

Equity Swaps also provide the following benefits over plain vanilla equity

investing:

1. An investor in a physical holding of shares loses possession on the shares once

he sells his position. However, using an equity swap the investor can pass on the

negative returns on equity position without losing the possession of the shares and

hence voting rights. For example, let's say A holds 100 shares of a Petroleum

Company. As the price of crude falls the investor believes the stock would start

giving him negative returns in the short run. However, his holding gives him a

strategic voting right in the board which he does not want to lose. Hence, he enters

into an equity swap deal wherein he agrees to pay Party B the return on his shares

against LIBOR+25bps on a notional amt. If A is proven right, he will get money

from B on account of the negative return on the stock as well as LIBOR+25bps on

the notional. Hence, he mitigates the negative returns on the stock without losing

on voting rights.

2. It allows an investor to receive the return on a security which is listed in such a

market where he cannot invest due to legal issues. For example, let's say A wants

to invest on script X listed in Country C. However, A is not allowed to invest in

Country C due to capital control regulations. He can however, enter into a contract

with B, who is a resident of C, and ask him to buy the shares of company X and

provide him with the return on share X and he agrees to pay him a fixed / floating

rate of return.

Equity Swaps, if effectively used, can make investment barriers vanish and help an

investor create leverage similar to those seen in derivative products.

Investment banks that offer this product usually take a riskless position by hedging

the client's position with the underlying asset. For example, the client may trade a

swap - say Vodafone. The bank credits the client with 1,000 Vodafone at GBP1.45.

The bank pays the return on this investment to the client, but also buys the stock in

the same quantity for its own trading book (1,000 Vodafone at GBP1.45). Any

equity-leg return paid to or due from the client is offset against realised profit or

loss on its own investment in the underlying asset. The bank makes its money

through commissions, interest spreads and dividend rake-off (paying the client less

of the dividend than it receives itself). It may also use the hedge position stock

(1,000 Vodafone in this example) as part of a funding transaction such as such as

stock lending,repo or as collateral for a loan.

Forex swap

in finance, a forex swap (or FX swap) is a simultaneous purchase and sale of

identical amounts of one currency for another with two different value dates

(normally spot to forward).[1]; see Foreign exchange derivative.

Structure

A forex swap consists of two legs:

a spot foreign exchange transaction, and

a forward foreign exchange transaction.

These two legs are executed simultaneously for the same quantity, and therefore

offset each other.

It is also common to trade forward-forward, where both transactions are for

(different) forward dates.

Uses

By far and away the most common use of FX swaps is for institutions to fund their

foreign exchange balances.

Once a foreign exchange transaction settles, the holder is left with a positive (or

long) position in one currency, and a negative (or short) position in another. In

order to collect or pay any overnight interest due on these foreign balances, at the

end of every day institutions will close out any foreign balances and re-institute

them for the following day. To do this they typically use tom-next swaps, buying

(selling) a foreign amount settling tomorrow, and selling (buying) it back settling

the day after.

The interest collected or paid every night is referred to as the cost of carry. As

currency traders know roughly how much holding a currency position will make or

cost on a daily basis, specific trades are put on based on this; these are referred to

as carry trades.

Pricing

The relationship between spot and forward is as follows:

where:

F = forward rate

S = spot rate

r1 = simple interest rate of the term currency

r2 = simple interest rate of the base currency

T = tenor (calculated according to the appropriate day count convention)

The forward points or swap points are quoted as the difference between forward

and spot, F - S, and is expressed as the following:

where r1 and r2 are small. Thus, the absolute value of the swap points increases

when the interest rate differential gets larger, and vice versa.

Interest rate swap

A swap is a derivative in which one party exchanges a stream of interest payments

for another party's stream of cash flows. Interest rate swaps can be used by hedgers

to manage their fixed or floating assets and liabilities. They can also be used by

speculators to replicate unfunded bond exposures to profit from changes in interest

rates. Interest rate swaps are very popular and highly liquid instruments.

Structure

A is currently paying floating, but wants to pay fixed. B is currently paying fixed

but wants to pay floating. By entering into an interest rate swap, the net result is

that each party can 'swap' their existing obligation for their desired obligation.

In an interest rate swap, each counterparty agrees to pay either a fixed or floating

rate denominated in a particular currency to the other counterparty. The fixed or

floating rate is multiplied by a notional principal amount (say, USD 1 million).

This notional amount is generally not exchanged between counterparties, but is

used only for calculating the size of cashflows to be exchanged.

The most common interest rate swap is one where one counterparty A pays a fixed

rate (the swap rate) to counterparty B, while receiving a floating rate (usually

pegged to a reference rate such as LIBOR). According to usual market convention,

the counterparty paying the fixed rate is called the "payer", and the counterparty

paying the floating rate is called the "receiver".

A pays fixed rate to B (A receives variable rate)

B pays variable rate to A (B receives fixed rate).

Consider the following swap in which Party A agrees to pay Party B periodic fixed

interest rate payments of 8.65%, in exchange for periodic variable interest rate

payments of LIBOR + 70 bps (0.70%). Note that there is no exchange of the

principal amounts and that the interest rates are on a "notional" (i.e. imaginary)

principal amount. Also note that the interest payments are settled in net (e.g. Party

A pays (LIBOR + 1.50%)+8.65% - (LIBOR+0.70%) = 9.45% net). The fixed rate

(8.65% in this example) is referred to as the swap rate.[1]

At the point of initiation of the swap, the swap is priced so that it has a net present

value of zero. If one party wants to pay 50 bps above the par swap rate, the other

party has to pay approximately 50 bps over LIBOR to compensate for this.

[edit] Types

Normally the parties do not swap payments directly, but rather each sets up a

separate swap with a financial intermediary such as a bank. In return for matching

the two parties together, the bank takes a spread from the swap payments (in this

case 0.30% compared to the above example)

Being OTC instruments interest rate swaps can come in a huge number of varieties

and can be structured to meet the specific needs of the counterparties. By far the

most common are fixed-for-floating, fixed-for-fixed or floating-for-floating. The

legs of the swap can be in the same currency or in different currencies. (A single-

currency fixed-for-fixed rate swap is generally not possible; since the entire cash-

flow stream can be predicted at the outset there would be no reason to maintain a

swap contract as the two parties could just settle for the difference between the

present values of the two fixed streams; the only exceptions would be where the

notional amount on one leg is uncertain or other esoteric uncertainty is introduced).

[edit] Fixed-for-floating rate swap, same currency

Party B pays/receives fixed interest in currency A to receive/pay floating rate in

currency A indexed to X on a notional amount N for a term of T years. For

example, you pay fixed 5.32% monthly to receive USD 1M Libor monthly on a

notional USD 1 million for 3 years. The party that pays fixed and receives floating

coupon rates is said to be short the interest swap because it is expressed as a bond

convention (as prices fall, yields rise). Interest rate swaps are simply the exchange

of one set of cash flows for another.

Fixed-for-floating swaps in same currency are used to convert a fixed rate

asset/liability to a floating rate asset/liability or vice versa. For example, if a

company has a fixed rate USD 10 million loan at 5.3% paid monthly and a floating

rate investment of USD 10 million that returns USD 1M Libor +25 bps monthly, it

may enter into a fixed-for-floating swap. In this swap, the company would pay a

floating rate of USD 1M Libor+25 bps and receive a 5.5% fixed rate, locking in

20bps profit.

[edit] Fixed-for-floating rate swap, different currencies

Party P pays/receives fixed interest in currency A to receive/pay floating rate in

currency B indexed to X on a notional N at an initial exchange rate of FX for a

tenure of T years. For example, you pay fixed 5.32% on the USD notional 10

million quarterly to receive JPY 3M (TIBOR) monthly on a JPY notional 1.2

billion (at an initial exchange rate of USD/JPY 120) for 3 years. For

nondeliverable swaps, the USD equivalent of JPY interest will be paid/received

(according to the FX rate on the FX fixing date for the interest payment day). No

initial exchange of the notional amount occurs unless the Fx fixing date and the

swap start date fall in the future.

Fixed-for-floating swaps in different currencies are used to convert a fixed rate

asset/liability in one currency to a floating rate asset/liability in a different

currency, or vice versa. For example, if a company has a fixed rate USD 10 million

loan at 5.3% paid monthly and a floating rate investment of JPY 1.2 billion that

returns JPY 1M Libor +50 bps monthly, and wants to lock in the profit in USD as

they expect the JPY 1M Libor to go down or USDJPY to go up (JPY depreciate

against USD), then they may enter into a Fixed-Floating swap in different currency

where the company pays floating JPY 1M Libor+50 bps and receives 5.6% fixed

rate, locking in 30bps profit against the interest rate and the fx exposure.

[edit] Floating-for-floating rate swap, same currency

Party P pays/receives floating interest in currency A Indexed to X to receive/pay

floating rate in currency A indexed to Y on a notional N for a tenure of T years.

For example, you pay JPY 1M LIBOR monthly to receive JPY 1M TIBOR

monthly on a notional JPY 1 billion for 3 years.

Floating-for-floating rate swaps are used to hedge against or speculate on the

spread between the two indexes widening or narrowing. For example, if a company

has a floating rate loan at JPY 1M LIBOR and the company has an investment that

returns JPY 1M TIBOR + 30 bps and currently the JPY 1M TIBOR = JPY 1M

LIBOR + 10bps. At the moment, this company has a net profit of 40 bps. If the

company thinks JPY 1M TIBOR is going to come down (relative to the LIBOR) or

JPY 1M LIBOR is going to increase in the future (relative to the TIBOR) and

wants to insulate from this risk, they can enter into a float-float swap in same

currency where they pay, say, JPY TIBOR + 30 bps and receive JPY LIBOR + 35

bps. With this, they have effectively locked in a 35 bps profit instead of running

with a current 40 bps gain and index risk. The 5 bps difference (w.r.t. the current

rate difference) comes from the swap cost which includes the market expectations

of the future rate difference between these two indices and the bid/offer spread

which is the swap commission for the swap dealer.

Floating-for-floating rate swaps are also seen where both sides reference the same

index, but on different payment dates, or use different business day conventions.

These have almost no use for speculation, but can be vital for asset-liability

management. An example would be swapping 3M LIBOR being paid with prior

non-business day convention, quarterly on JAJO (i.e. Jan, Apr, Jul, Oct) 30, into

FMAN (i.e. Feb, May, Aug, Nov) 28 modified following・

Floating-for-floating rate swap, different currencies

Party P pays/receives floating interest in currency A indexed to X to receive/pay

floating rate in currency B indexed to Y on a notional N at an initial exchange rate

of FX for a tenure of T years. For example, you pay floating USD 1M LIBOR on

the USD notional 10 million quarterly to receive JPY 3M TIBOR monthly on a

JPY notional 1.2 billion (at an initial exchange rate of USDJPY 120) for 4 years.

To explain the use of this type of swap, consider a US company operating in Japan.

To fund their Japanese growth, they need JPY 10 billion. The easiest option for the

company is to issue debt in Japan. As the company might be new in the Japanese

market without a well known reputation among the Japanese investors, this can be

an expensive option. Added on top of this, the company might not have appropriate

debt issuance program in Japan and they might lack sophisticated treasury

operation in Japan. To overcome the above problems, it can issue USD debt and

convert to JPY in the FX market. Although this option solves the first problem, it

introduces two new risks to the company:

FX risk. If this USDJPY spot goes up at the maturity of the debt, then when

the company converts the JPY to USD to pay back its matured debt, it

receives less USD and suffers a loss.

USD and JPY interest rate risk. If the JPY rates come down, the return on

the investment in Japan might go down and this introduces an interest rate

risk component.

The first exposure in the above can be hedged using long dated FX forward

contracts but this introduces a new risk where the implied rate from the FX spot

and the FX forward is a fixed rate but the JPY investment returns a floating rate.

Although there are several alternatives to hedge both the exposures effectively

without introducing new risks, the easiest and the most cost effective alternative

would be to use a floating-for-floating swap in different currencies. In this, the

company raises USD by issuing USD Debt and swaps it to JPY. It receives USD

floating rate (so matching the interest payments on the USD Debt) and pays JPY

floating rate matching the returns on the JPY investment.

Fixed-for-fixed rate swap, different currencies

Party P pays/receives fixed interest in currency A to receive/pay fixed rate in

currency B for a term of T years. For example, you pay JPY 1.6% on a JPY

notional of 1.2 billion and receive USD 5.36% on the USD equivalent notional of

10 million at an initial exchange rate of USDJPY 120.

Other variations

A number of other variations are possible, although far less common. Mostly

tweaks are made to ensure that a bond is hedged "perfectly", so that all the interest

payments received are exactly offset by the swap. This can lead to swaps where

principal is paid on one or more legs, rather than just interest (for example to hedge

a coupon strip), or where the balance of the swap is automatically adjusted to

match that of a prepaying bond (such as RMBS Residential mortgage-backed

security)

Uses

Interest rate swaps were originally created to allow multi-national companies to

evade exchange controls. Today, interest rate swaps are used to hedge against or

speculate on changes in interest rates.

Speculation

Interest rate swaps are also used speculatively by hedge funds or other investors

who expect a change in interest rates or the relationships between them.

Traditionally, fixed income investors who expected rates to fall would purchase

cash bonds, whose value increased as rates fell. Today, investors with a similar

view could enter a floating-for-fixed interest rate swap; as rates fall, investors

would pay a lower floating rate in exchange for the same fixed rate.

Interest rate swaps are also very popular due to the arbitrage opportunities they

provide. Due to varying levels of creditworthiness in companies, there is often a

positive quality spread differential which allows both parties to benefit from an

interest rate swap.

The interest rate swap market is closely linked to the Eurodollar futures market

which trades at the Chicago Mercantile Exchange.

LIBOR/Swap zero rate

Since LIBOR only has maturities out to 12 months, and since interest rate swaps

often use LIBOR as the reference rate, interest rate swaps can be used as a proxy to

extend the LIBOR yield curve out past 12 months.

British local authorities

In June 1988 the Audit Commission was tipped off by someone working on the

swaps desk of Goldman Sachs that the London Borough of Hammersmith and

Fulham had a massive exposure to interest rate swaps. When the commission

contacted the council, the chief executive told them not to worry as "everybody

knows that interest rates are going to fall"; the treasurer thought the interest rate

swaps were a 'nice little earner'. The controller of the commission, Howard Davies

realised that the council had put all of its positions on interest rates going down; he

sent a team in to investigate.

By January 1989 the commission obtained legal opinions from two Queen's

Counsel. Although they did not agree, the commission preferred the opinion which

made it ultra vires for councils to engage in interest rate swaps. Moreover interest

rates had gone up from 8% to 15%. The auditor and the commission then went to

court and had the contracts declared illegal (appeals all the way up to the House of

Lords failed); the five banks involved lost millions of pounds. Many other local

authorities had been engaging in interest rate swaps in the 1980s, although

Hammersmith was unusual in betting all one way.[2]

Valuation and pricing

Further information: Rational_pricing#Swaps

The present value of a plain vanilla (i.e. fixed rate for floating rate) swap can easily

be computed using standard methods of determining the present value (PV) of the

fixed leg and the floating leg.

The value of the fixed leg is given by the present value of the fixed coupon

payments known at the start of the swap, i.e.

where C is the swap rate, M is the number of fixed payments, P is the notional

amount, ti is the number of days in period i, Ti is the basis according to the day

count convention and dfi is the discount factor.

Similarly, the value of the floating leg is given by the present value of the floating

coupon payments determined at the agreed dates of each payment. However, at the

start of the swap, only the actual payment rates of the fixed leg are known in the

future, whereas the forward rates (derived from the yield curve) are used to

approximate the floating rates. Each variable rate payment is calculated based on

the forward rate for each respective payment date. Using these interest rates leads

to a series of cash flows. Each cash flow is discounted by the zero-coupon rate for

the date of the payment; this is also sourced from the yield curve data available

from the market. Zero-coupon rates are used because these rates are for bonds

which pay only one cash flow. The interest rate swap is therefore treated like a

series of zero-coupon bonds. Thus, the value of the floating leg is given by the

following:

where N is the number of floating payments, fj is the forward rate, P is the notional

amount, tj is the number of days in period j, Tj is the basis according to the day

count convention and dfj is the discount factor. The discount factor always starts

with 1. The discount factor is found as follows:

[Discount factor in the previous period]/[1 + (Forward rate of the floating

underlying asset in the previous period × Number of days in period/360)].

(Depending on the currency, the denominator is 365 instead of 360; e.g. for GBP.)

The fixed rate offered in the swap is the rate which values the fixed rates payments

at the same PV as the variable rate payments using today's forward rates, i.e.:

[3]

Therefore, at the time the contract is entered into, there is no advantage to either

party, i.e.,

Thus, the swap requires no upfront payment from either party.

During the life of the swap, the same valuation technique is used, but since, over

time, the forward rates change, the PV of the variable-rate part of the swap will

deviate from the unchangeable fixed-rate side of the swap. Therefore, the swap

will be an asset to one party and a liability to the other. The way these changes in

value are reported is the subject of IAS 39 for jurisdictions following IFRS, and

FAS 133 for U.S. GAAP. Swaps are marked to market by debt security traders to

visualize their inventory at a certain time.

Risks

Interest rate swaps expose users to interest rate risk and credit risk.

Interest rate risk originates from changes in the floating rate. In a plain

vanilla fixed-for-floating swap, the party who pays the floating rate benefits

when rates fall. (Note that the party that pays floating has an interest rate

exposure analogous to a long bond position.)

Credit risk on the swap comes into play if the swap is in the money or not. If

one of the parties is in the money, then that party faces credit risk of possible

default by another party.

Market size

The Bank for International Settlements reports that interest rate swaps are the

second largest component of the global OTC derivative market. The notional

amount outstanding as of June 2009 in OTC interest rate swaps was $342 trillion,

up from $310 trillion in Dec 2007. The gross market value was $13.9 trillion in

June 2009, up from $6.2 trillion in Dec 2007.

Interest rate swaps can now be traded as an Index through the FTSE MTIRS Index.

Equity swap

An equity swap is a financial derivative contract (a swap) where a set of future

cash flows are agreed to be exchanged between two counterparties at set dates in

the future. The two cash flows are usually referred to as "legs" of the swap; one of

these "legs" is usually pegged to a floating rate such as LIBOR. This leg is also

commonly referred to as the "floating leg". The other leg of the swap is based on

the performance of either a share of stock or a stock market index. This leg is

commonly referred to as the "equity leg". Most equity swaps involve a floating leg

vs. an equity leg, although some exist with two equity legs.

An equity swap involves a notional principal, a specified tenor and predetermined

payment intervals.

Equity swaps are typically traded by Delta One trading desks.

Examples

Parties may agree to make periodic payments or a single payment at the maturity

of the swap ("bullet" swap), the worst case.

Take a simple index swap where Party A swaps £5,000,000 at LIBOR + 0.03%

(also called LIBOR + 3 basis points) against £5,000,000 (FTSE to the £5,000,000

notional). In this case Party A will pay (to Party B) a floating interest rate (LIBOR

+0.03%) on the £5,000,000 notional and would receive from Party B any

percentage increase in the FTSE equity index applied to the £5,000,000 notional.

In this example, assuming a LIBOR rate of 5.97% p.a. and a swap tenor of

precisely 180 days, the floating leg payer/equity receiver (Party A) would owe

(5.97%+0.03%)*£5,000,000*180/360 = £150,000 to the equity payer/floating leg

receiver (Party B).

At the same date (after 180 days) if the FTSE had appreciated by 10% from its

level at trade commencement, Party B would owe 10%*£5,000,000 = £500,000 to

Party A. If, on the other hand, the FTSE at the six-month mark had fallen by 10%

from its level at trade commencement, Party A would owe an additional

10%*£5,000,000 = £500,000 to Party B, since the flow is negative.

For mitigating credit exposure, the trade can be reset, or "marked-to-market"

during its life. In that case, appreciation or depreciation since the last reset is paid

and the notional is increased by any payment to the pricing rate payer or decreased

by any payment from the floating leg payer.

Applications

Typically Equity Swaps are entered into in order to avoid transaction costs

(including Tax), to avoid locally based dividend taxes, limitations on leverage

(notably the US margin regime) or to get around rules governing the particular type

of investment that an institution can hold.

Equity Swaps also provide the following benefits over plain vanilla equity

investing:

1. An investor in a physical holding of shares loses possession on the shares once

he sells his position. However, using an equity swap the investor can pass on the

negative returns on equity position without losing the possession of the shares and

hence voting rights. For example, let's say A holds 100 shares of a Petroleum

Company. As the price of crude falls the investor believes the stock would start

giving him negative returns in the short run. However, his holding gives him a

strategic voting right in the board which he does not want to lose. Hence, he enters

into an equity swap deal wherein he agrees to pay Party B the return on his shares

against LIBOR+25bps on a notional amt. If A is proven right, he will get money

from B on account of the negative return on the stock as well as LIBOR+25bps on

the notional. Hence, he mitigates the negative returns on the stock without losing

on voting rights.

2. It allows an investor to receive the return on a security which is listed in such a

market where he cannot invest due to legal issues. For example, let's say A wants

to invest on script X listed in Country C. However, A is not allowed to invest in

Country C due to capital control regulations. He can however, enter into a contract

with B, who is a resident of C, and ask him to buy the shares of company X and

provide him with the return on share X and he agrees to pay him a fixed / floating

rate of return.

Equity Swaps, if effectively used, can make investment barriers vanish and help an

investor create leverage similar to those seen in derivative products.

Investment banks that offer this product usually take a riskless position by hedging

the client's position with the underlying asset. For example, the client may trade a

swap - say Vodafone. The bank credits the client with 1,000 Vodafone at GBP1.45.

The bank pays the return on this investment to the client, but also buys the stock in

the same quantity for its own trading book (1,000 Vodafone at GBP1.45). Any

equity-leg return paid to or due from the client is offset against realised profit or

loss on its own investment in the underlying asset. The bank makes its money

through commissions, interest spreads and dividend rake-off (paying the client less

of the dividend than it receives itself). It may also use the hedge position stock

(1,000 Vodafone in this example) as part of a funding transaction such as stock

lending,repo or as collateral for a loan.

Total return swap

Total return swap, or TRS (especially in Europe), or total rate of return swap,

or TRORS, is a financial contract which transfers both the credit risk and market

risk of an underlying asset.

Diagram explaining Total return swap

Contract definition

Let us assume that one bank (bank A) owns an asset (e.g. a bond) which

periodically gives interest rate payments. Assume that bank A (the protection

buyer) and bank B (the protection seller) have entered a total return swap contract.

According to this contract, bank A is paying all interest payments on the reference

asset, plus any capital gains (positive price changes of the asset) over the payment

period to bank B. Furthermore, bank B is paying LIBOR plus a spread as well as

any negative price changes of the asset. In case of a default of the underlying asset,

the asset is valued to zero and bank B has to pay the full initial market price of the

asset (which was valid at the start of the contract).

The reference asset may be any asset, index, or basket of assets. TRORS are

particularly popular on bank loans, which do not have a liquid repo market.

[edit] Advantage of using Total Rate Swaps

The TRORS allows one party to derive the economic benefit of owning an asset

without putting that asset on its balance sheet, and allows the other (which does

retain that asset on its balance sheet) to buy protection against loss in its value.[1]

A similar situation is if bank A gives bank B a loan used to finance the transfer of

ownership of the underlying asset from bank A to bank B. In this case bank B gets

the same capital flows as in the case of a total rate swap (with indefinite contract

length). Here the underlying asset is used as collateral for the loan. The use of a

total rate swap in this situation is advantageous to bank A, because the bank has no

potential legal problems selling the underlying asset (because this asset is in the

ownership of the bank).[2]

TRORS can be categorised as a type of credit derivative, although the product

combines both market risk and credit risk, and so is not a pure credit derivative.

When loans are structured as a “total return swap” — the lending party's claims

will not be stayed along with other creditors’ if the borrowing party files for

Chapter 11 bankruptcy. The lender can extract payments it is owed outside of the

normal bankruptcy process.[3]

Users

Hedge funds are using Total Return Swaps to obtain leverage on the Reference

Assets: they can receive the return of the asset, typically from a bank (which has a

funding cost advantage), without having to put out the cash to buy the Asset. They

usually post a smaller amount of collateral upfront, thus obtaining leverage.

Hedge funds (such as The Children's Investment Fund (TCI)) have attempted to

use Total Return Swaps to side-step public disclosure requirements enacted under

the Williams Act. As discussed in CSX Corp. v. The Children's Investment Fund

Management, TCI argued that it was not the beneficial owner of the shares

referenced by its Total Return Swaps and therefore the swaps did not require TCI

to publicly disclose that it had acquired a stake of more than 5% in CSX. The

United States District Court rejected this argument.[4]

Total Return Swaps are also very common in many structured finance transactions

such as Collateralized Debt Obligations (CDOs). CDO Issuers often enter TRS

agreements as protection seller in order to leverage the returns for the structure's

debt investors. By selling protection, the CDO gains exposure to the underlying

asset(s) without having to put up capital to purchase the assets outright. The CDO

gains the interest receivable on the reference asset(s) over the period while the

counterparty mitigates their market of risk.

Variance swap

A variance swap is an over-the-counter financial derivative that allows one to

speculate on or hedge risks associated with the magnitude of movement, i.e.

volatility, of some underlying product, like an exchange rate, interest rate, or stock

index.

One leg of the swap will pay an amount based upon the realised variance of the

price changes of the underlying product. Conventionally, these price changes will

be daily log returns, based upon the most commonly used closing price. The other

leg of the swap will pay a fixed amount, which is the strike, quoted at the deal's

inception. Thus the net payoff to the counterparties will be the difference between

these two and will be settled in cash at the expiration of the deal, though some cash

payments will likely be made along the way by one or the other counterparty to

maintain agreed upon margin.

Contents

1 Structure and features

2 Pricing and valuation

3 Uses

4 Related instruments

5 References

Structure and features

The features of a variance swap include:

the variance strike

the realised variance

the vega notional: Like other swaps, the payoff is determined based on a

notional amount that is never exchanged. However, in the case of a variance

swap, the notional amount is specified in terms of vega, to convert the

payoff into dollar terms.

The payoff of a variance swap is given as follows:

where:

Nvar = variance notional (a.k.a. variance units),

= annualised realised variance, and

= variance strike.[1]

The annualised realised variance is calculated based on a prespecified set of

sampling points over the period. It does not always coincide with the classic

statistical definition of variance as the contract terms may not subtract the mean.

For example, suppose that there are n+1 sample points S0,S1,...,Sn. Define, for i=1

to n, Ri = ln(Si / Si-1), the natural log returns. Then

where A is an annualisation factor normally chosen to be approximately the

number of sampling points in a year (commonly 252). It can be seen that

subtracting the mean return will decrease the realised variance. If this is done, it is

common to use n − 1 as the divisor rather than n, corresponding to an unbiased

estimate of the sample variance.

It is market practice to determine the number of contract units as follows:

where Nvol is the corresponding vega notional for a volatility swap.[1] This makes

the payoff of a variance swap comparable to that of a volatility swap, another less

popular instrument used to trade volatility.

[edit] Pricing and valuation

The variance swap may be hedged and hence priced using a portfolio of European

call and put options with weights inversely proportional to the square of strike[2][3].

Any volatility smile model which prices vanilla options can therefore be used to

price the variance swap. For example, using the Heston model, a closed-form

solution can be derived for the fair variance swap rate. Care must be taken with the

behaviour of the smile model in the wings as this can have a disproportionate

effect on the price.

We can derive the payoff of a variance swap using Ito's Lemma. We first assume

that the underlying stock is described as follows:

Applying Ito's formula, we get:

Taking integrals, the total variance is:

We can see that the total variance consists of a rebalanced hedge of and short a

log contract.

Using a static replication argument [4] , i.e., any twice continuously differentiable

contract can be replicated using a bond, a future and infinitely many puts and calls,

we can show that a short log contract position is equal to being short a futures

contract and a collection of puts and calls:

Taking expectations and setting the value of the variance swap equal to zero, we

can rearrange the formula to solve for the fair variance swap strike:

Where:

S0 is the initial price of the underlying security,

S * > 0 is an arbitrary cutoff,

K is the strike of the each option in the collection of options used.

Often the cutoff S * is chosen to be the current forward price S * = FT = S0erT, in

which case the fair variance swap strike can be written in the simpler form:

Uses

Many traders find variance swaps interesting or useful for their purity. An

alternative way of speculating on volatility is with an option, but if one only has

interest in volatility risk, this strategy will require constant delta hedging, so that

direction risk of the underlying security is approximately removed. What is more, a

replicating portfolio of a variance swap would require an entire strip of options,

which would be very costly to execute. Finally, one might often find the need to be

regularly rolling this entire strip of options so that it remains centered around the

current price of the underlying security.

The advantage of variance swaps is that they provide pure exposure to the

volatility of the underlying price, as opposed to call and put options which may

carry directional risk (delta). The profit and loss from a variance swap depends

directly on the difference between realized and implied volatility.[5]

Another aspect that some speculators may find interesting is that the quoted strike

is determined by the implied volatility smile in the options market, whereas the

ultimate payout will be based upon actual realized variance. Historically, implied

variance has been above realized variance[6], a phenomenon known as the Variance

risk premium, creating an opportunity for volatility arbitrage, in this case known as

the rolling short variance trade. For the same reason, these swaps can be used to

hedge Options on Realized Variance.