Forward, Futures and Swaps

INVESTMENTS

Forwards, Futures & Swaps

Interest Rate Derivatives

Interest rate swaps, caps, floors, and swaptions are over the counter (OTC) interest rate derivatives.

Broadly defined, a derivative instrument is a formal agreement between two parties specifying the exchange of cash payments based on changes in the price of a specified underlying item or differences in the returns of different securities.

For example, interest rate swaps are based on differences be-tween two different interest rates, while interest rate caps/floors are option like instruments

on interest rates.

Unlike the organized exchanges, the OTC market is an informal market

consisting of dealers or market makers, who trade price information and negotiate transactions over electronic communications networks.

Although a great deal of contract standardization exists in the OTC market, dealers active in this market custom tailor agreements to meet the specific needs of their customers.

And unlike the organized exchanges, where the exchange clearinghouses guarantee contract performance through a system of margin requirements

combined with the daily settlement of gains or losses, counterparties

to OTC derivative agreements must bear some default or credit risk.

According to data released by BIS, the total estimated notional amount of outstanding OTC contracts stood at $94 trillion at end June 2000. The interest segment expanded by 7%, to $64.1 trillion.

* The total notional amount of interest rate swaps is $48 trillion, among which, $17 trillion goes to USD swaps.

* At the same time, the total public debt (including Treasuries and local government debt) outstanding in the U.S. is $5 trillion.

* The total notional amount of interest rate options is 9 trillion.

The History of Swaps

A swap contract is an obligation to pay a fixed amount and receive a floating amount at the end of every period for a pre-specified number of periods.

Each date on which payments are made is called a settlement date. If the fixed amount exceeds the floating amount on a settlement date, the buyer of the swap pays the seller the difference in cash. If the floating amount exceeds the fixed amount on a settlement date, the seller of the swap pays the buyer the difference in cash. In either

case, this difference is conveyed in the form of a difference check.

A swap contract is equivalent to a portfolio of forward contracts with identical delivery prices and different maturities. Consequently, swap contracts are similar to forwards in that:

- at any date, swap contracts can have positive, negative, or no value.

- at initiation, the fixed amount paid is chosen so that the swap contract is costless. The unique fixed amount which zeros out the value of a swap contract is called the swap price.

Figure 1: Fixed/floating side of swap-contract

Our coverage of swaps will be limited as it is covered in depth in the Money and Capital Markets class. We will focus on the pricing and hedging of these instruments.

The first swap was a currency swap involving the World bank and IBM in 1980.

The first interest rate swap was a 1982 agreement in which the Student

Loan Marketing Association (Sallie Mae) swapped the interest payments on an issue of intermediate term, fixed rate debt for floating

rate payments indexed to the three month Treasury bill yield.

In a (standard) currency swap, the buyer receives the difference be-tween the dollar value of one foreign currency unit (e.g., the dollar

value of 1 pound) and a fixed amount of domestic currency (e.g., 2 dollars) at every settlement date (e.g., every 6 months). Since the spot exchange rate at each settlement date is random, the dollar value of the foreign currency unit is also random. If this difference is negative, the swap buyer pays the absolute value of the difference to the swap seller.

Similarly, in an equity index swap, the buyer receives the difference

between the dollar value of a stock index and a fixed amount of dollars at every settlement date.

The most common type of swap is an interest rate swap. The buyer of an interest rate swap receives the difference between the interest computed using a floating interest rate (e.g., LIBOR) and the interest

computed using a fixed interest rate (e.g., 5% per 6 months) at every settlement date (e.g., every 6 months). The interest is computed

by reference to a notional principal (e.g., $100 mio.), which never changes hands. If the floating side of an equity index or interest rate swap is calculated

by reference to an index or interest rate in a foreign country, then there is currency risk, in addition to the usual equity or interest rate risk.

If the currency is negatively correlated with the underlying, this currency risk is actually desirable. Nonetheless, many swap con-tracts are quoted with a fixed currency component, so that only the equity or interest rate risk remains.

The Growth of the Swap Market

Almost all swaps are traded over-the-counter (OTC). However, ex-changes are now trying to list swaps.

Swaps usually go out from 2 years up to 10 years. This is called the tenor of the swap.

It was estimated by the International Swap Dealers Association (ISDA) that as of June 30, 1997 about US$23.7 trillion worth of currency and interest rate swaps notional value existed, of which more than 93% comprise interest rate swaps. (Source: ISDA's Web Page at http://www.isda.org/)

Initially, banks acted as intermediaries trying to match a swap buyer with a seller. Over time, banks emerged as counterparties to swaps as they learned to lay off their risk using other derivatives such as exchange-traded futures. This is known as warehousing and the transactions are referred to as "matched-book" trading.

Using futures to hedge swap books is cost-effective but results