CFA Level 1 Swap Markets and Contracts - Part IA

Reading 74: Swap Markets and Contracts
The candidate should be able to:
a. describe the characteristics of swap contracts and explain how swaps are
terminated;
b. define and give examples of currency swaps, plain vanilla interest rate swaps,
and equity swaps, and calculate and interpret the payments on each.


Introduction

Swaps are derivative instruments customized to the requirements of the parties involved. The two parties involved are called counterparties.

IN a swap the two counterparties agree to exchange a stream of future cash for a specified period of time based upon agreed upon parameters in some underlying commodity or market index or currency.

The period of time for which the swap will be in operation is called tenor of the swap.

A swap calls for periodic payments.

swaps are over the counter transactions between two parties.

swap markets have swap facilitators. Swap facilitators help clients find ways via the swap market to alter or avoid unwanted risks.

Swap facilitators act as financial engineers and design swaps to solve client problems.

Swap facilitators act as brokers and bring counterparties together.

Swap facilitators act as dealers who enter into swap agreements with others as principals and carry the swaps on their books.

Swap dealers engage in offsetting swaps., whereby their long positions and short positions net to as close to zero position as possible. Through their understanding of the market for swaps and prices at which various parties are willing to enter into swaps, dealers price their quotes in which they are principals so as to earn a bid-ask spread on their overall book, even if their net exposure were to be zero. Sometimes, dealers may keep some net exposure when they feel the potential returns outweigh the risks.

Keeping a net position means, they will not offset the transaction immediately but wait for sometime to benefit from change in swap prices.

Termination of swaps

Swaps are normally designed with the intention of holding the position till the termination date.

If in case a party changes his mind and wants to get out of the swap, he may go to a dealer and ask for an offsetting swap. It may enter separately into another swaps that offsets the earlier swap and both swaps remain in force but the net effect for a firm is eqaul to terminating the swap. But with both swaps in force, the firm would be facing credit risk. Hence it is better to go in for direct termination of the swap from the origical dealer.

Forward swaps and swaptions also can be used to provide offsetting positions to existing swaps.

Source:
An introduction to Derivatives and Risk Management by Don Chance, Thomson South Western, 2004