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Paper Topic:

Advantages & Disadvantages Of Swap

Swaps

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Swaps are over-the-counter instruments involving the exchange of one stream of payment liabilities for another . Before 1980 swaps scarcely existed . By 1985 they were seen to offer great advantage to issuers (and investors ) of debt securities because , with them , a party could lower the cost of financing in bond markets , or raise the yield on bond investments , through arbitrage and by exploiting comparative advantages Indeed , swaps had become so much a part of the international financial scene that Eurobond transactions involving swaps were responsible at

br times for more that half of all new issues . Also , since about 1987 banks and other financial intermediaries have found swaps extremely beneficial in managing the special risks of interest-rate and currency exposures from loan or investment portfolios . Swaps are enormously accommodating--they enable parties to change their financial assets and liabilities at will and at low cost , for example , to change a fixed-interest payment obligation into a variable one , or to change a dollar-payment obligation into a deutsche mark one

Swaps constitute valid and binding agreements between participants to exchange one stream of future interest (and sometimes principal payments for another . Swaps , however , represent contingent values and therefore do not appear on balance sheets , except in footnotes . Since 1985 they have been transacted according to standardized documentation and almost always involve counterparties of high creditworthiness . The growth of interest-rate and currency swaps has been exceptional since their origin

In the early years of modern international capital markets , around the mid-1960s , foreign exchange controls that blocked or impeded the flow of funds across bs were abundant . In the days of fixed exchange rates the conventional method of preventing funds from exiting or entering one 's country was to surround the country with a ring of exchange controls . For example , if a British pension fund manager wanted to invest in the U .S . equity market , he or she would either have to sell an existing overseas asset to pay for the new investment or purchase international "investment currency " to do so . Investment currency was rigged to be more expensive than domestic currency , and buying it was in effect the same as buying dollars for the U .S . investment at a premium or paying a higher rate for the dollars than otherwise prevailed Similarly , if a U .S . company wanted to make a capital investment in its manufacturing facility in Manchester , it was under considerable pressure from U .S . authorities (finally legalized by regulations issued by the Commerce Department 's Office of Foreign Direct Investment , now extinct to finance the investment with funds borrowed outside the United States even if that should mean (as it did until the late 1970s ) that the cost of financing would be greater than what was available to the company domestically

To accommodate the requirements of both such parties , the "back to back or "parallel " loan was devised . The U .S . firm would lend an agreed amount of dollars to a U .S . affiliate of the British pension fund , and in a separate but "parallel " transaction the U .K . pension fund would lend the same amount in sterling to a U .K . affiliate of the American company . Two loan agreements were required , both containing substantially the same terms and conditions , often including provisions for "topping up " or reducing the amount of one loan as an offset to the changed market value of the other . Such changes would occur because of changes in the dollar / pound sterling rate . The loans did provide substantial value to each party , but the cost of arranging and executing them consumed a large portion of this value , especially when the principal amounts were small , which was often the case . Credit considerations were complex , even though the loans provided for a mutual offset in the case of default , and agreement on interest rates was often difficult to achieve when the maturities involved exceeded the one- to 2-year periods for which forward foreign exchange rates could reliably be obtained . Banks were often asked to stand in the middle , to ease questions of counterpart credit exposure , though such arrangements added further to the cost of the transactions . Accountants ruled that because of the offsetting provisions , the loans would not have to be included on the face of the companies ' financial statements , which provided an advantage that direct borrowing from a foreign bank would not . After a time , much of the process was made easier by the familiarity of participants and the standardization of some of the procedures , but the overall volume of parallel loans was very modest by current standards

After the collapse of the Bretton Woods fixed-exchange-rate system and the adoption of floating exchange rates , controls governing the international transfer of funds became obsolete and began to be removed The U .S . regulations were rescinded in 1973 , the British government abolished exchange controls in 1979 , and other countries followed suit thereafter . Parallel loans were no longer necessary , and immediately disappeared . Some of the financial principles underlying the parallel loan market , however , were deemed to have wider application and served as the basis for the swap markets that succeeded them

A few years later , in August 1981 , a significant transaction took place in which IBM and the World Bank agreed to exchange the future liabilities associated with borrowings in the Swiss franc and U .S dollar bond markets , respectively . IBM was then perceived in Switzerland as one of the two or three best "names " from the United States and was therefore able to borrow Swiss francs in the Swiss market on extremely favorable terms compared with all other foreign borrowers--that is , at about the same rate as the Swiss government . The World Bank , having used the Swiss market several times in recent years and being involved with third-world loans , was not regarded quite so favorably by the Swiss and was therefore required to pay a higher rate than the best U .S credits-about 20 basis points above the Swiss government rate . On the other hand , the World Bank , like IBM at the time , carried an AAA rating and was well respected as a credit in the U .S . dollar markets because of the backing of the U .S , German , Japanese , and other governments . The World Bank could borrow in the United States at rates only narrowly higher (e .g , 40 basis points ) than those of U .S . Treasuries , but IBM would have had to pay a slightly higher rate than this

Thus , if each borrowed in the market in which its comparative advantage was the greatest--that is , if IBM borrowed Swiss francs and the World Bank borrowed dollars--both borrowings would be at rates superior to the available alternatives . If they then swapped the liabilities each had incurred , the World Bank would create Swiss francs synthetically at a bargain rate , saving 10 basis points on the transaction , and IBM would save 15 basis points with its synthetic dollar financings . The parties had similar credit ratings so counterparty risk was offset

The way it worked was this : The World Bank borrowed at 5 basis points more advantageously than IBM could have done in dollars , and IBM borrowed at 20 basis points better in Swiss francs than the best rate offered the World Bank . IBM relent its Swiss francs to the World Bank at 10 basis points more than it paid for them . The World Bank thus gained net , a 10-basis-point advantage over its alternative Swiss franc borrowing cost , and IBM gained a net , a 15-basis-point advantage by combining the World Bank 's 5-basis-point advantage in dollars with the 10 basis points that it kept for itself on the Swiss franc fnancing . The value received by each party was the product of negotiation since then market-makers quote prices for swaps that reflect the net demand of thousands of different market users br

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Werent (Today , currency swaps involving fixed rate to floating rate are also available ) The World Bank had created a synthetic Swiss franc security for itself that had all of the properties of the real thing and IBM had done the same in dollars

In the period preceding the IBM-World Bank currency swap , it was possible to arrange for foreign exchange purchases and sales in the forward markets , although as indicated , these markets did not always operate beyond one- to two-year maturities . Swaps are now the instrument for hedging foreign exchange exposure beyond a year . The growth of this market segment has put pressure on governments with restrictions on foreign exchange transactions to drop such restrictions which the swap market can easily frustrate . Accordingly considerable growth in nondollar currency swaps has occurred in recent years . Swaps in virtually all major currencies are now available

Having observed currency swaps develop , some bankers began to think of ways to apply the same idea to transactions involving short- and long-term dollar borrowings . They were encouraged by the existence of different credit risk premia in the fixed-rate and floating-rate term debt markets . For example , a weaker credit such as a BBB-rated industrial company would have to pay as much as 70 basis points more than an AAA-rated bank for a five-year bond issue , but it would have to pay only 30 basis points more for a five-year bank loan based on LIBOR So the BBB company could maximize its comparative advantage by borrowing from its bank and swapping the floating-rate interest payment obligation with , say , a Japanese bank for a stream of fixedrate interest payments that the Japanese bank had incurred through the issuance of Eurobonds The Japanese bank would pass on its fixed-rate obligation to the BBB company at , say , its cost of funds plus a premium of 50 basis points The BBB company would then be able to create a synthetic five-year fixed-rate borrowing at 20 basis points less than its alternative cost of funds . The Japanese bank assumes the BBB company 's floatinginterest-rate obligation to pay LIBOR plus 30 basis points , but it reduces this by the 50-basis-point spread that it made in the fixed-rate bond swap , resulting in a net cost of funds of LIBOR minus 20 basis points . In this way an interest-rate swap was created . Many more followed , with further modifications and improvements . A secondary market in swaps subsequently developed . New applications were introduced rapidly as volume built up and the number of participants and intermediaries increased sharply

Two basic types of interest-rate swaps have become common since 1981 "coupon swaps (of fixed-rate to floating-rate swaps such as the one just illustrated , and "basis swaps " in which floating-rate obligations indexed to different reference rates are exchanged . An example of the latter is a swap between a rate indexed to U .S . Treasuries and one indexed to LIBOR . Basis swaps also include exchange of rate obligations indexed to the same reference , but for different maturities (e .g 30-day LIBOR vs . 90-day LIBOR

Through the end of 1982 , the interest-rate swap market had operated in mainly an international context . During 1983 , however , a large volume of swaps developed between exclusively domestic U .S . counterparties . Top quality borrowers , such as Student Loan Marketing Association , would issue fixed-rate securities to swap them into floating-rate obligations to fund their essentially floating-rate loan portfolio at a lower cost

Then a major new use for interest-rate swaps was found in the distressed U .S . savings and loan industry . These organizations had fallen into great difficulty as a result of financing fixed-rate home mortgages from the proceeds of floating-rate deposits . When interest rates soared in the late 1970s , many savings and loan institutions suffered heavy losses . As rates began to decline again in the early 1980s , some S Ls sold fixed-rate debt securities , collateralized by mortgages , to pay down variable-rate liabilities . Others simply swapped their existing floating-rate funding obligations into fixed-rate obligations , again offering existing mortgages as collateral

Although commodity futures have long existed , commodity swaps are still young and steadily gaining popularity . Quite similar is the case of equity swaps . In addition , new types of swaps are continuously being engineered to suit specific needs of hedgers . Interest rate differential swaps , credit swaps , yield curve swaps , and LIBOR-in-arrears swaps are a few specialized swap arrangements that are illustrated here . The mechanics of these swaps are very similar to those of interest rate swaps . The interest rate index is replaced by another index that can be effectively hedged by a counterparty . Because only notional values of underlying assets are considered , and merely net difference in cash flows exchanged between counterparties , commodity and equity swaps can be regarded as variants of interest rate swaps . For commodity swaps , the underlying commodity can range anywhere from oil to wheat . Equally wide is the variety for equity swaps . In case foreign equity is one of the indexes , the resulting swap becomes akin to a currency swap where the exchange rate also has a role to play in determining the notional value of the swap

As the market for swap transactions grew , comparable developments were occurring in the field of financial futures and options . Financial futures became available in many different currencies and instruments and came to be traded on futures exchanges in London , Paris , Zurich Frankfurt , Singapore , and Tokyo , in addition to the futures markets in the United States . Through sophisticated use of financial and foreign exchange futures contracts , new ways of hedging against interest-rate and foreign exchange exposures were developed . Ultimately , these resulted in the ability of dealers to sell options on hedged positions which they carried on their own books

Soon , markets were being made in option contracts in which purchasers could , in effect , acquire insurance against future risk exposures . The ability of the dealer to price options that it was selling to others became crucial to the dealer 's operation . Whereas the dealer collects the premium at the outset , the actual result of the contract would not be known for some time , often for several months . If the dealer had misjudged the value of the options that were sold at the beginning of the year , it might not know it until nearly the end of the year--although after a time the development of an active secondary market in various types of options clearly revealed the value of the positions

Gradually , the financial market environment became much more sensitive to and aware of sophisticated hedging devices and strategies . Many of these were based on the improving understanding in the market of the many uses and values of swaps , futures , and options transactions used in various combinations , called swaptions . The swaption market includes any option that gives the buyer the right , but not the obligation , to enter into a swap on a future date . It also includes any option that allows an existing swap to be terminated or extended by one of the counterparties Some of the more recent swaptions have included forward swaps , caps and floors , collars , callable /putable swaptions , and contingent swaps

References

Bartolini , Leonardo (2002 . Foreign Exchange Swaps . New England Economic Review

Bjoerk , Tomas (2004 . Arbitrage Theory in Continuous Time . Oxford University Press

Heely , James A . and Nersesian , Roy L (1993 . Global Management Accounting : A Guide for Executives of International Corporations . Quorum Books Malhotra ,D .K (1997 . An Empirical Examination of the Interest Rate Swap Market . Quarterly Journal of Business and Economics , 36 Neave , Edwin H (1998 . Financial Systems : Principles and Organisation Routledge

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