Swap
- Relevant to paper P4
Risk management is a compulsory session of P4 study. Swap is a strategy of risk management of foreign exchange risk and interest rate risk. Therefore, this article will introduce the definition and types of swap risk management, and then discuss the details of swap bank, market and etc.
Definitions
What are interest rate and currency swaps?
They are methods used to hedge long-term interest rate risk and foreign exchange risk (unlike forward, future, option and money market hedging which are short-term methods)
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What is an interest rate swap financing?
A contract in which two counterparts make arrangements to exchange cash flows at intermittent intervals.
Swap Bank
A Financial Institution that facilitates swaps between counterparties.It can be an international commerce bank, an investment bank, amerchant bank or an independent operator.
It serves in two different ways:
l Swap broker. It matches counterparties but does not assumeany risk of the swap.It receives a commission for the service.
l Swap dealer or Market maker. It accepts either side of acurrency swap, and then later dismiss it, or match it with acounterparty. This is more risky.As a result of the higher risk taken on, it receives a part of thecash flows passed through.
Most of swap banks nowadays are swap dealers/market makers
Swap Market quotations
Swap banks work:
- making a market in basic interest rate swaps (known as“plain vanilla” )
- personalizing the terms of interest rate and currency swapsto customers’ needs.
- providing current market quotations applicable tocounterparties with Aa or Aaa credit ratings (extremelyfinancially reliable counterparties).
Conventional quotations:
Interest rate swap rates for a currency against a local standardreference in the same currencyCurrency swap rates against dollar LIBOR
Other types of Interest rate and Currency swaps (1)
1. Zero-Coupon-for-floating-rate swap
Zero Coupon for floating the floating-rate payer makes the standard periodic floating-ratepayments over the life of the swap, while the fixed-rate payermakes a single payment at the end of the swap
2. Floating-for-floating-interest rate swap
each counterparty is tied to a different floating-rate index or adifferent frequency of the same index. For a swap to be possible,a QSD must still exist!
3. Fixed-for floating currency rate
one counterparty is tied to a fixed-rate whereas the other is tiedto floating-rate. The debt service obligations are denominated indifferent currencies
4. Floating-for-floating currency rate
both the counterparties are tied to a floating-rate. The debtservice obligations are denominated in different currencies
5. Amortizing currency swap
they incorporate an amortization feature in which periodically theamortized portions of the notional principals are re-exchanged.
Risks of Interest rate and Currency swaps
Belonging to swap bank
1. Interest rate risk
risk of interest rates changing unfavorably before the swap bankcan lay off on an opposing counterparty the other of aninterest rate swap
2. Basis risk
risk of a situation in which the counterparties are tied to differentfloating-rates. The difference in the indexes is known as thebasis. Since the indexes are not perfectly correlated the swapmay not always be profitable for the bank
3. Exchange rate risk
refers to the risk that a swap bank faces from fluctuatingexchange rates during the time it takes for the bank to lay off aswap it undertakes with one counterparty with an oppositecounterparty
4. Credit risk
the major risk: it refers to the possibility that a counterparty willdefault. The swap bank that stays between the two counterpartiesis obligated only to the no defaulting counterparty
5. Mismatch risk
is the problem of finding an opponent for a swap which the bankhas agreed to take. The mismatch may be with respect to the sizeof the principal sums, the maturity dates or the debt service dates.
6. Sovereign risk
the possibility that a country will impose exchange restrictions on acurrency involved in a swap
Efficiency of Swap Market
Currency swap.
The reasons to use it are:
to obtain debt financing at the swapped currency at a lowerinterest cost brought about through comparative advantageseach counterparty has in its national capital market
to hedge long-run exchange rate exposure
Interest rate swap.
The reasons to use it are:
better match maturities of assets and liabilities
to obtain a cost saving due to the quality spread differential.In efficient markets it is difficult to accept the existence of
QSD: it implies the presence of an arbitrage opportunity dueto some mispricing of the default risk premiums on differenttypes of debt instruments. BUT not all types of debtinstruments are regularly available for all borrowers, so theinterest rate swap market helps tailoring the more suitable
Prepared by Golden ACCA R&D Center
December, 2012
高顿网校特别提醒：已经报名2013年ACCA考试的考生可按照复习计划有效进行！另外，高顿网校2013年ACCA考试辅导高清课程已经开通，通过针对性地讲解、训练、答疑、模考，对学习过程进行全程跟踪、分析、指导，可以帮助考生全面提升备考效果。
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