VOLUME 1, NO. 2
This is the first weekly commentary of Derivatives 'R Us. If you don't know what this is, please refer to Volume 1, No. 1, February 24.
Of course today there is some hot news. Barings, a old British Bank, has failed due to some speculative futures trading. You re probably waiting for my thoughts on this matter, but it s really too early to put anything definitive in print. The Bank of England is still sorting things out and they have far better access to information than anyone else. If a conversation starts up in this group (I ll be surprised if it doesn t), I may jump in as I learn more. If it warrants a treatment, I ll either do a special issue later this week or comment on it next week. In the meantime, I ll stick with my original game plan, which is, for the next few weeks, to give introductory treatments of some key derivative contracts. For those of you who are more knowledgeable, be patient. Or click on that File Exit command right now.
This week's topic is:
***** SWAPS *****
No, this is not exchanging spouses. Swaps are extremely popular financial transactions that have come to be the most widely used derivative. It s unlikely that any of you will do one in your personal financial transactions, but believe it or not, you ve almost surely already done something similar to a swap, even without trading futures. Why should you care about swaps? If you care about futures (I take that as given), then you need to know who some of the major players are in the futures markets, particularly the Eurodollar futures markets, and what they are doing. If you think Eurdollar volume has grown because all of sudden everybody discovered Eurodollars, think again. The swap dealers are hedging their risk with Eurodollar futures. When you ve got million of dollars principal value, on which you ll have to make interest payments, a Eurodollar futures hedge is an obvious choice.
A swap is a contract between two parties in which the first party promises to make a payment to the second while the second party promises to make a payment to the first, with both payments occurring on a set of scheduled dates. The two sets of payments are determined according to different formulas.
The most common type of swap is the interest rate swap. Usually an interest rate swap involves one set of payments being determined by the Eurodollar (LIBOR) rate while the other set is fixed at an agreed-upon rate, normally corresponding to the yield on a Treasury note with comparable maturity plus a spread of so many basis points. However, other types of arrangements are possible. Some interest rate swaps have both sets of payments tied to floating rates. Interest rate swaps involve only the exchange of interest payments based on a face value, called the notional principal, but the notional principal itself is never exchanged. At each payment date, the party who owes more to the other makes a net payment so only one party in fact makes a payment.
There are several other types of swaps. Currency swaps involve one party making payments in one currency and another making payments in another currency. In commodity swaps one set of payments is based on the price of a commodity, such as oil, while the other can be fixed or based on some other floating rate or price. Finally, we have equity swaps, which involve one party paying the other a rate based on the rate of return on an equity index like the S&P 500 or the DAX. The other party makes a payment based on something else like maybe a fixed rate, LIBOR, or another equity index. I predict equity swaps will be the wave of the future because they make it very simple, easy and inexpensive to reallocate your portfolio to a different equity sector.
The notional principal of outstanding swaps is somewhere between 6 and 12 trillion dollars. (What's a few trillion when you're having fun?) Swaps are susceptible to default since they aren't guaranteed by any clearinghouse. Parties are sometimes required to post collateral or mark to market periodically, just like in the futures markets. Speaking of futures, swaps can be shown to be virtually identical to a strip of futures contracts with different expirations. That s why the Eurodollar futures hedge works.
Oh by the way, I said you had probably done a swap before. My favorite analogy to a swap is an apartment lease. You enter into an agreement to make a fixed payment on each of a set of prespecified dates and the other party agrees to grant you the use of a service, which clearly has some value, however indeterminate it may be, to you. That value may change over time as your needs change.
This week's topic is just a brief introduction to swaps. I could probably write 500 pages on this topic. If you want to know more, there are an increasing number of books written on the subject but do keep in mind that these instruments are primarily for the use of corporations and financial institutions. Check in a book store that specializes in financial books if you re in Chicago or New York.
RECOMMENDATION: I recently finished reading a good financial thriller called "Zero Coupon" by Paul Erdman. He's a former Swiss banker who has written about ten finance novels. Zero Coupon is a real treat but does require that you know something about derivatives and municipal bonds. There's not a lot of sex and violence in this book (which I guess can be either to your liking or not) but it is a real page turner. I had previously read Erdman's Crash of '79 and the Silver Bears (the latter was made into a movie) but I lost track of him in the 80s, though he continued to write. I plan to explore more of his books. I also recently finished his "The Swiss Account" but it wasn't quite as good.