Swaps and Other Derivatives: Valuable Tools or Instruments of the Devil?

Daniel Penzing
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What Are Swaps?

Swaps and other derivatives are products that are meant to reduce the amount of risk that an investor faces. There are all kinds of swaps, and they can be structured in many different ways. For example, one structure might be for Bank A to pay a fixed rate and receive the three-month LIBOR. This way, Bank A would be guaranteed a fixed rate on the loan they give out. Another structure might be a plain vanilla currency swap.

The US dollar has been in a bull market for the last 15 years. The cost of food, housing, and all kinds of other basic goods has gone up. A lot of investors have gone out of their way to accumulate the US dollar because most financial market vehicles are priced in US dollars. However, if you are holding US dollars and this trend reverses, it could have a drastic impact on the value of your investment portfolio.

If you’re a speculator, you’re likely to take advantage of this movement by strategically selling US dollars and investing in a cheaper currency. However, if you’re an investor and you have a diversified portfolio, buying foreign currencies can be much riskier. You can't forget about the quality of the assets in the currency.

The Danger of Credit Default Swaps

Someone who is long on a corporate bond is most likely feeling pretty good at the moment. This is because the value of the bond has been going up and US interest rates have been coming down. The 10-year US government bond, a benchmark for all financial assets and especially corporate bonds, had fallen from 4.25% in May 2013 to 3.137% by July 2015.

Headline Bond Rates

At this time, it has been a great year to be invested in corporate bonds. Thanks to the falling interest rates, the value of the bonds has gone up. Everyone is happy.

Soon, there may be some other smiling faces. Bondholders may be wishing the yields would go back up. Holders of credit default swaps (CDS) … that is, insurance protection … on US corporate bonds will be celebrating.

How Long have Credit Default Swaps Been Around?

¹ Credit default swaps have been around for quite a while. In fact, they were around before Fannie Mae and the US Federal Reserve. In 1748, there was a bank run in Europe that started when things went bad in Amsterdam. In those days, the only way to transfer money within a country was to use a letter of credit from a bank and the bankers of the national capital helped process those letters. Today, that practice is done by the postal service.

Counterparty Risk

Opening yourself up to counterparty risk when you enter into a swap contract or other derivatives contract is often a very bad idea. Many people don’t understand that counterparty risk isn’t just a dirty word in the world of finance anymore, and it’s something that every investor needs to be concerned about.

Explaining counterparty risk and how it can affect you is a bit more complex. When you enter into a swap or derivative contract, your counterparty is the person you’re trading with. Different investors will enter into different contracts and use the swaps and other derivatives in different ways. In the end, the counterparty risk is the amount of risk you take on when you enter into a swap or derivative contract.

Why Does Counterparty Risk Matter?

One of the biggest concerns about counterparty risk is that you may not know a lot about the person who you’re entering a swap or derivative contract with.

This lack of knowledge can make it hard to figure out if you should trust them or not. The only way that you can really know if you can trust your counterparty is if you know if they’re trustworthy. Since you don’t know much about them, this poses a bit of a problem.

What Are Futures?

Futures are contracts for commodity delivery. The contract, or the delivery agreement, will state the commodity to be delivered to the buyer, the location of delivery, the delivery date and the price agreed upon by a buyer and a seller.

So when a dairy farmer in upstate New York wants to deliver 50,000 gallons of milk to a collector in Florida in May, they could enter into a futures agreement that locks in a price.

Agricultural futures are called farmland futures, and they allow producers to fix the price of commodities they are going to deliver in the future. With a futures agreement, the farmer can negotiate the price of milk before the cows even start milking.

The farmer will commit to delivering milk to the collector, and the collector will deliver a lump sum payment to the farmer. This is called a cash-settlement contract. If the price of milk changes during the time, the farmer or the collector will be declared the loser.

In the Midwest, we have a different version of futures. Instead of milk, we have corn and soybeans. There are two types of futures in the market: cash settlement and physical delivery.

The Risks

If a U.S. corporation wants to invest 10 million dollars in a foreign bank, chances are that there are no such dollars in the foreign bank. The corporation will need to exchange the money for local currency at the current exchange rate.

Banks generally are happy to make this exchange, as they are in the business of facilitating these kind of trades at a profit.

In most cases, a transaction involving the exchange of one currency for another will not attract tax or regulatory scrutiny. Nonetheless, a trader who is risking the bank’s capital is going to be required to seek the approval of the bank’s senior management.

The traders will generally seek to purchase protection against fluctuations in the exchange rate between the U.S. dollar and the foreign currency. In other words, the traders will allow someone else to take on the exchange rate risk of the trade in exchange for money.

This is known as a derivative, since the payout is originally derived from some other trade (or exchange of assets).

What Are Options?

An option is a contract between two parties that gives the buyer the right, but not the obligation, to buy or sell a specified amount of an underlying asset at a specified price on or before a specified date. A derivative is essentially an option whose payoff depends on the price of something else. For example, if you buy one share of GE stock, you have a claim to receive a certain amount of money from GE in the future. The "future" is the main thing that makes a derivative different from a tradable asset. Many different kinds of derivatives exist. Some of the most common are currency options, stock options, futures contracts, and forward contracts.

Any particular derivative requires the existence of a sub-class of options that can be used to replicate it. For example, a futures contract can be replicated using two calls (one to purchase the underlying asset at a fixed price, and the other to sell the underlying asset at the same price). In this case, the two calls constitute "legs."

As a general rule, the more exotic the derivative, the more specialized the replication technique, and the more complex the replication technique, the harder it will be to price the derivative.

Summary

By now, you may have heard about swaps and other derivatives being variously described as tools of the devil, or even innocuous instruments. This blog post seeks to provide an education on the various forms of derivatives, focusing on the swap, specifically.

Swaps are derivatives related to interest rates that can be used for a variety of purposes by banks and investors. While there is a great deal of discussion about what role a bank should play in the economy, there is none about the role of derivatives; our focus here will be on the swap.

The swap has been around for a long time and will probably be around for a long time to come. Yet, the swap doesn’t seem to be well understood, especially by investors. In this post, we’ll explain what a swap is. We’ll talk about its hedging properties and how that has made it very useful to corporate investors, particularly during the recent financial crisis. We’ll also discuss the various types of swaps and the role they’ve played in helping governments in different countries manage their financial obligations.