SWAPS

Risks of Interest Rate and Currency Swaps Interest Rate Risk Interest rates might move against the swap bank after it has only gotten half of a swap on the books, or if it has an unhedged position. Basis Risk If the floating rates of the two counterparties are not pegged to the same index. Exchange rate Risk In the example of a currency swap given earlier, the swap bank would be worse off if the pound appreciated.

Risks of Interest Rate and Currency Swaps (continued) Credit Risk This is the major risk faced by a swap dealer—the risk that a counter party will default on its end of the swap. Mismatch Risk It’s hard to find a counterparty that wants to borrow the right amount of money for the right amount of time. Sovereign Risk The risk that a country will impose exchange rate restrictions that will interfere with performance on the swap.

Pricing a Swap A swap is a derivative security so it can be priced in terms of the underlying assets: How to: Any swap’s value is the difference in the present values of the payment streams that are incoming and outgoing. Plain vanilla fixed for floating swaps get valued just like a pair of bonds. Currency swap gets valued just like two nests of currency forward contracts.

FRN BONDs A note with a variable interest rate. The adjustments to the interest rate are usually made every six months and are tied to a certain money-market index. Also known as a "floater". These protect investors against a rise in interest rates (which have an inverse relationship with bond prices), but also carry lower yields than fixed notes of the same maturity. It's essentially the same concept as an adjustable-rate mortgage, except FRNs are investments (not debt).

Credit Risk in the Swap Markets The entry to a swap agreement costs nothing initially. In IRS the credit exposure is low, since there is no principal transacted. As we have seen the value of a swap can take negative or positive values during its life. The credit risk arises only when the swap value is positive. Creditworthiness of the counterparties is the crucial question. The good estimation of the credit rate of each firm can produce good profit (arbitrage) using swaps (this is one of the reasons for the tremendous growth of IRS markets).

RISK IN FRN BONDs FRNs carry little interest rate risk. A FRN has a duration close to zero, and its price shows very low sensitivity to changes in market rates. When market rates rise, the expected coupons of the FRN increase in line with the increase in forward rates, which means its price remains constant. Thus, FRNs differ from fixed rate bonds, whose prices decline when market rates rise. As FRNs are almost immune to interest rate risk, they are considered conservative investments for investors who believe market rates will increase. The risk that remains is credit risk.

CREDIT DEFAULT RISK Credit default swaps (CDS) are the most widely used type of credit derivative and a powerful force in the world markets. How They Work A CDS contract involves the transfer of the credit risk of municipal bonds, emerging market bonds, mortgage-backed securities, or corporate debt between two parties. It is similar to insurance because it provides the buyer of the contract, who often owns the underlying credit, with protection against default, a credit rating downgrade, or another negative "credit event." The seller of the contract assumes the credit risk that the buyer does not wish to shoulder in exchange for a periodic protection fee similar to an insurance premium, and is obligated to pay only if a negative credit event occurs. It is important to note that the CDS contract is not actually tied to a bond, but instead references it. For this reason, the bond involved in the transaction is called the "reference obligation." A contract can reference a single credit, or multiple credits.

CREDIT DEFAULT RISK As mentioned above, the buyer of a CDS will gain protection or earn a profit, depending on the purpose of the transaction, when the reference entity (the issuer) has a negative credit event. If such an event occurs, the party that sold the credit protection, and who has assumed the credit risk, must deliver the value of principal and interest payments that the reference bond would have paid to the protection buyer. With the reference bonds still having some depressed residual value, the protection buyer must, in turn, deliver either the current cash value of the referenced bonds or the actual bonds to the protection seller, depending on the terms agreed upon at the onset of the contract. If there is no credit event, the seller of protection receives the periodic fee from the buyer, and profits if the reference entity's debt remains good through the life of the contract and no payoff takes place. However, the contract seller is taking the risk of big losses if a credit event occurs.

Concluding Remarks The growth of the swap market has been astounding. Swaps are off-the-books transactions. Swaps have become an important source of revenue and risk for banks