Swaps were created out of a response to the deficiencies of certain financial instruments that were prevalent up to the early 1980s. Specifically in relation to parallel and back-to-back loans, banks found that it was necessary to modify the conditions inherent in these transactions to reap maximum benefits and make them cater more closely to their individual financial needs. Swaps therefore arose out of a need remedy the shortcomings of traditional loan facilities.
Evidently swaps are therefore primarily concerned with loans and specifically adjusting repayment options to meet the demands of the individual firms in response to their own institutional goals and overall market trends.
The initial motivation behind the development of swaps was to address the security and accounting difficulties that came about when countries/firms were borrowing in different currencies (Poitras 1992). Currency swaps, which will be discussed further on, were therefore the first innovations of the swap market.
Subsequently other variants have come up which address the various global financial needs of firms.
In order to understand what these new variants of swaps are it is essential to have an understanding of their scope and how they are managed. When financiers speak about swaps they are usually referring to an exchange between two parties of a similar financial obligation with a corresponding set of characteristics for another set with characteristics more desirable on each side.
It is essential to note that a swap is an arrangement which both parties feel is of more benefit than the original agreement they had (Malhotra 1997).
Certain concepts are usually highlighted when discussing the swap market. Firms who come into agreement on a swap are referred to as counterparties. The term notional principal is also widely used. This is actual face value of the swap. The nominal principal is the total principal value of the asset or liability being used to enter into the swap agreement. As opposed to loans which are often threatened with prepayment penalties, swaps are more flexible.
Depending on the arrangements between the counterparties, one or both party may opt to repay the debt earlier than agreed (Harris 2004). Additionally swaps could function as investment instruments. If the interest rates that at the close of the agreement are higher than the rates at initial start-up the contracting parties stand to gain from the difference. This is however, quite risky and most researchers advise against using the swap market for this purpose because of the unpredictability of the interest rate. In the same way interest rates could go up they could also go down proving a loss for the firm.
The swap market, probably because of its late development, is still not effectively regulated and has been noted to be very fragmented. The market started with focus being placed on the exchange of currencies from the late 1970s to the early 1980s. Later other variants were added. Interest rate swaps, which were introduced around the early 1980s as well, have now eclipsed interest rate swaps in terms of their share of the market and the number of firms that are making use of them. One author observes that the interest rate swaps are now the most popular of the swap derivatives that are now being used.
Still equity and commodity swaps were introduced to further meet the changing needs and demands of firms seeking to benefit from the potential advantages offered by the swap market. As the swap market developed firms began to realize notice the variety of purposes for which swaps could be used. In more recent times even the variants previous mentioned have themselves undergone considerable modifications and alterations to the point where whole new categories of swaps have been formed that have been modified from the original ‘plain vanilla’ swap which only offered the basic cash flow exchange (Poitras 1992).
The determination of swap types was therefore, done on a haphazard basis, as the need arose. The International Swap Dealers Association has been recently formed to address, among other things, regulating the swap instruments and standardizing swap terms. Despite the proliferation of various forms and variants of swaps there is one pervading feature of all, they entail the exchange of a cash flow by two parties who believe that the option being exchange for is more beneficial than the one previously possessed and the notional value of the swap on both sides is estimated to be of equal value (Poitras, 1992).
An interest rate swap is usually between two counterparties wishing to exchange one form of interest payment for another that has the same value. The most common type of interest rate swap is a fixed-for-floating rate swap (Malhotra 1997). In this form of interest rate swap the first party pays the second party a fixed interest rate on the swap’s notional principal at specified intervals. In return the second party accepts a floating-rate payment on a similarly valued notional principal. At the settlement of the swap contract both parties exchange the difference between the fixed and floating interest rates.
Assuming that there are no costs involved in initiating this transaction and neither party defaults, then the parties either gain from increases in interest rates or settle on par to where they were before. In the final case a swap would be a zero-sum agreement where neither parties gain financially from the transaction. An interest rate swap usually takes place between a dealer and a financial institution. The dealer is able to exchange either a floating interest rate for a fixed rate or exchange a fixed rate for a floating rate over a prescribed period of time.
Market trends have seen dealers swapping floating rates for fixed rates because of the rise in interest rates. Such exchanges help firms to save considerable sums of money as they thereby avoid losses from shifts in interest rates. Because the interest rate is itself very unsteady, dealers have to use prudence and analyze the market carefully before they decide on the best course of action to take so as not to end up losing. As Harris (2004) emphasizes “dealers can lose money on swaps if interest rates move in the opposite direction from the one they anticipate. ”
Among the variants of interest rate swaps have been noted. Yam (2000) observes several varieties which include amortizing, annuity and mortgage swaps which aim to match the amortizing schedule of swaps; next an accreting swap provides for a flexible notional principal allowing it to accumulate for the duration of the swap agreement; off-market swaps allow the fixed or floating rates to have different notional values; forward swaps allow firms to swap products on the market based on anticipated future returns. A currency swap involves parties exchanging one currency for another over a specified period of time.
Currency swaps allow parties to avoid the loss of possible movements in exchange rates. The parties entering the agreement temporarily exchanges one currency for the other during the time agreed in order to crystallize it up-front. This agreement is usually entered upon when parties are very uncertain about how market forces would change the value of a desired currency over time. A useful scenario outlined by Yam (2000) suggests that one party is in possession of US dollars but needs some Hong Kong dollars for three months without being exposed to any shifts in the exchange rate of the US within the three months.
The first party sells the US dollars at the current market rate with the agreement to repurchase them at the adjusted market rate at the close of the agreement. Other forms of currency swaps are currency coupon swaps which are much like an interest rate swap, where the floating interest rate is paid in one currency and the fixed interest rate is paid in the other currency. Among the currencies that are commonly exchanged are the European and North American currencies as well as in the Japanese yen, the Australian, Hong Kong and New Zealand dollars (Poitras 1992).
Commodity and equity swaps are the other mainstream variants and they two have their own subsets. The most common commodity swap is the plain vanilla fixed-for-floating swap. Firms may consider a commodity swap as a means of evade certain market risks associated with essential commodities such as oil. Equity stocks on the other hand would exchange the interest arrangements on a bond for cash flows which are linked to a stock index (Yam 2000). Given the varying nature of the types of swaps available, it is quite evident that firms are using swaps to meet an even wider range of needs than initially used in the 1980s.
However, inherent to a swap arrangement is finding two companies, usually one local and the other international, who have complementary needs as it refers to swap portfolios. (Worzala, Johnson & Lizieri 1997) acknowledge that it can be a great task for both parties if they are seeking to locate partners individually. Here is where financial intermediaries get involved. They provide the essential linkage between each of the parties, matching their individual needs as close together as possible.
Thereby both parties would be matched based on the similarities in the amount of money needed, the time-period for which it is needed and which would generate the same cash flow. They therefore play a significant role in facilitating the negotiation of swap agreements. Even though swaps do present financial risks to the investors that are involved in them, they have been noted to have a comparably better advantage than normal back-to-back loans. Both arrangements face possible default from among the contracting parties.
However Malhotra (1997) suggests that there are notable differences between the risks involved in case of a default on a swap and a loan. Usually in a loan only one party is subject to the risk of default while in a swap both parties face equal exposure and therefore none has an advantage over the other. Further, risks in case of a default on a swap, is strictly limited to the notional principal times the difference between the two interest rates at the settlement date. Additionally, depending on the swap contract signed to, if one party defaults provisions are made to automatically absolve the remaining party of any obligations.
Essential default is much riskier on a loan than on a swap contract. Worzala, Johnson & Lizieri (1997) highlight an additional way in which swaps are different from and better than back-to-back loans. They suggest that currency swaps are less risky as they remove the traditional risks that have been associated with regular loans. Particularly in a currency exchange, only a single transaction is required. The currency amounts are sold and not lent and then they are later re-exchanged. In accounting for this specific type of swap transactions accountants have been noted to consider it a mere foreign currency transaction and not as a debt.
When the swap is reversed at the end of the agreement the transaction is considered a forward contract (137). One of the major limitations of the swap market is its vulnerability to shock. Firms have been known to use the swap market for investment. This however is not a very safe action as changes in interest rate could have potentially severe repercussions on the firms concerned. Immediately prior to September 11, 2001 many dealers enjoyed the fixed interest rates available on the market. However the terrorist attacks on the Twin Towers saw interest rates take a turn for the worst.
These investors now had their swaps locked in at very high interest rates. Further there exists very few regulations governing the swap market. Increasing regulators are calling for serious analysis of the state of the swap market but these reports have not been coming in as quickly as anticipated. In any case, with firms accounting for swap transactions in such unique ways on their balance sheets, collecting empirical data on the number of firms involved and the type of transactions they use would be a very challenging task.
Generally swap houses and market makers are the ones most closely involved in negotiating these contracts. These make their profits from the bid-offer spread which is the difference between the initial and final bids on the swap less administrative fees. (Malhotra 1997). With new developments in information communication technology it has become increasingly easier for firms to make contact with prospective counterparties without having to go through the middle man. In conclusion, the swap market is still relatively new and therefore not enough information is available for a useful analysis.
It is also quite difficult to predict trends in the movement and development of this very new type of financial transaction. This is compounded by the fragmented nature of the existing market. It is only with adequate research that correct descriptions and predictions are possible. Until then regulators need to careful monitor the activities of the institutions involved in the swap market to ensure that exposure to risks is kept to a minimum and that the effects of a crisis, if it occurs, will not impact the global economy too greatly.
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