Derivatives are financial contracts used to manage risk by transferring it from a party that wishes to reduce its exposure to another party that wishes to take on that exposure.
The value of a derivatives contract is dependent upon or derived from one or more underlying assets, such as a commodity, bond, equity, currency, or other reference value such as an interest rate or credit risk.
Derivatives play an important role in the capital markets and the broader economy. Companies in every state use derivatives to protect against risks that are inherent in their businesses. Derivatives are often and inappropriately portrayed as unregulated, arcane, and excessively risky instruments.
Many derivatives fall into the category of over-the-counter (OTC) derivatives, which means that their terms are privately negotiated between two parties rather than traded on an exchange with standardized terms. Examples of contracts that can be traded as OTC derivatives include:
• Forwards – contracts to buy or sell assets at a future date based on a price specified today.
• OTC Options – contracts to buy or sell an asset at a given price within a specified date.
• Swaps – contracts to exchange cash flows on an agreed schedule.
• Credit Default Swaps – contracts where a buyer makes a payment to a seller in return for a promise that the seller will compensate the buyer if a specified credit event occurs.
OTC derivatives offer flexibility in reducing risk exposure. For example, an electric utility can use OTC derivatives to hedge the risk of increases in fuel costs on the specific quantity of fuel it plans to purchase over a period of time so that its customers are protected against rate increases. OTC derivatives also help financial institutions hedge their exposure to credit risk, which then helps the financial institutions hedge their exposure to credit risk, which then helps the financial institution expand their lending capabilities.
Derivatives contracts can be divided into two general families:
1. Contingent claims, e.g. options
2. Forward claims, which include exchange-traded futures, forward contracts and swaps
A swap is an agreement between two parties to exchange sequences of cash flows for a set period of time. Usually, at the time the contract is initiated, at least one of these series of cash flows is determined by a random or uncertain variable, such as an interest rate, foreign exchange rate, equity price or commodity price. Conceptually, one may view a swap as either a portfolio of forward contracts, or as a long position in one bond coupled with a short position in another bond. This article will discuss the two most common and most basic types of swaps: the plain vanilla interest rate and currency swaps.
The Swaps Market
Unlike most standardized options and futures contracts, swaps are not exchange-traded instruments. Instead, swaps are customized contracts that are traded in the over-the-counter (OTC) market between private parties. Firms and financial institutions dominate the swaps market, with few (if any) individuals ever participating. Because swaps occur on the OTC market, there is always the risk of a counterparty defaulting on the swap.
Plain Vanilla Interest Rate Swap
The most common and simplest swap is a "plain vanilla" interest rate swap. In this swap, Party A agrees to pay Party B a predetermined, fixed rate of interest on a notional principal on specific dates for a specified period of time. Concurrently, Party B agrees to make payments based on a floating interest rate to Party A on that same notional principal on the same specified dates for the same specified time period. In a plain vanilla swap, the two cash flows are paid in the same currency. The specified payment dates are called settlement dates, and the time between are called settlement periods. Because swaps are customized contracts, interest payments may be made annually, quarterly, monthly, or at any other interval determined by the parties.
Plain Vanilla Foreign Currency Swap
The plain vanilla currency swap involves exchanging principal and fixed interest payments on a loan in one currency for principal and fixed interest payments on a similar loan in another currency. Unlike an interest rate swap, the parties to a currency swap will exchange principal amounts at the beginning and end of the swap. The two specified principal amounts are set so as to be approximately equal to one another, given the exchange rate at the time the swap is initiated.
Who Would Use a Swap?
The motivations for using swap contracts fall into two basic categories: commercial needs and comparative advantage. The normal business operations of some firms lead to certain types of interest rate or currency exposures that swaps can alleviate. For example, consider a bank, which pays a floating rate of interest on deposits (e.g. liabilities) and earns a fixed rate of interest on loans (e.g. assets). This mismatch between assets and liabilities can cause tremendous difficulties. The bank could use a fixed-pay swap (pay a fixed rate and receive a floating rate) to convert its fixed-rate assets into floating-rate assets, which would match up well with its floating-rate liabilities.
Exiting a Swap Agreement
Sometimes one of the swap parties needs to exit the swap prior to the agreed-upon termination date. This is similar to an investor selling an exchange-traded futures or option contract before expiration. There are four basic ways to do this:
1. Buy Out the Counterparty: Just like an option or futures contract, a swap has a calculable market value, so one party may terminate the contract by paying the other this market value. However, this is not an automatic feature, so either it must be specified in the swaps contract in advance, or the party who wants out must secure the counterparty's consent.
2. Enter an Offsetting Swap: For example, Company A from the interest rate swap example above could enter into a second swap, this time receiving a fixed rate and paying a floating rate.
3. Sell the Swap to Someone Else: Because swaps have calculable value, one party may sell the contract to a third party. As with Strategy 1, this requires the permission of the counterparty.
4. Use a Swaption: A swaption is an option on a swap. Purchasing a swaption would allow a party to set up, but not enter into, a potentially offsetting swap at the time they execute the original swap. This would reduce some of the market risks associated with Strategy 2
