Hello my name is Patrick Boyle, welcome back to my YouTube channel where we're
learning all about finance and derivatives. In today's video we're going
to learn all about swaps. OK so today we'll learn all about swaps what are
they? how do they work? who trades them? and how do they pay out? Instead of going
straight to a definition, let's just firstly discuss the idea of the swap. For
some reason, a lot of students really hate learning about swaps, as they think
that they're complicated and confusing, but in truth they're neither of these
things. A lot of the material that we've already covered about options, is a lot
more difficult than swaps. There is no complicated formula for valuing swaps or
anything like that, the way there is for options, so don't worry too much about
them and let's think about what they are. So when I teach this class at King's
College or Queen Mary University, I often start out with a story. I say, well let's
imagine that you're a university student and in the final year of your degree and
after the exams you go out with a drink with your best friend from college.
So the two you go out and you say, well we're just gonna have one drink righ?t
We'll have one quick drink, and then we'll go home you know, but the
night goes on you know, you have two or three drinks you have a few more and
things are getting a bit sloppy. You turn to your friend and you
say, you know you're the smartest person in the class, and your friend says no no
no you are by far the smartest person. you're, everyone thinks, everyone says
that you are the best student in this degree program. You will be the most
successful student. And you say to your friend, oh no no, you will be the most
successful student. I know this better than I know anything. And so the argument
goes on and o,n and you know you decide to have maybe another drink while you
discuss it. By the end of the night you've come to an agreement with your
friend. You've said to them you know what I have so much faith in you and how
smart you are and how well you're gonna do in life now what I'd like to do is
enter into an agreement with you what we'll do is we'll both go out and we'll
get the best jobs that we can get and well happen is that I at the end of each
month will sign over my paycheck to you you will sign over your paycheck to me
and because I have so much faith in you I think I'll do better with that
transaction and I will with just cashing my own paycheck and your friend agrees
and off you guys go so then as time passes what happens well you get you get
a really good job you know things work out for you you've got a really top job
but one of the top investment firms and you know you're you're making an awful
lot of money but of course the problem is that you're not really making a lot
of money because you're you're handing over your paychecks to this friend of
yours and your friend of course your friend actually was right there a lot of
faith in you and they knew you'd get a great job and so they just went they got
a job at a local restaurant you know they're flipping burgers at the
restaurant but they are receiving all of your big investment banking paychecks
you know so you are at this point will say a couple of years into it you're the
head of M&A at the biggest best investment bank and your friend is you
know there's there's still you know flipping hamburgers so what happens well
obviously you've lost out on that trade but really all that was all that
agreement that you entered into was just a swap, where we took two cash flows that
we didn't know what they would be and we agreed at time zero that they were
probably equivalent and we exchanged them and then of course after the event
we start to see what the two cash flows will be and we see who wins and who
loses in that transaction well let's think a little bit more about it so how
do we price that once once the swap is running you know once things are
happening we get to see the paychecks and we'll assume that people's paychecks
are just going to grow at the rate of inflation for example which is probably
a reasonable assumption maybe not early in your career but for a lot of people
it is and so all we need to do to price this transaction is we just need to
present value these two cash flows and the difference between the present value
of these two cash flows will be the amount you'd have to pay to get out of
that transaction now I guess I left out of that transaction maybe you had made
this agreement with your friend to do for five years you know so if we're
three years into it in order to value it you just have to look at the expected
cash flows of your income over the next two years and their expected cash flows
and the difference between these is how much this swap transaction is worth okay
so now you know what a swap is and how it works but let's see if we can come up
with a slightly more formal definition for one so a swap is a financial
derivative in which two counterparties exchange the cash flow of one party's
financial instrument for those of the other parties financial instrument for a
period of time stated in the agreement these cash flow streams are referred to
as the legs of the swap the swap agreement defines the dates when the
cash flows are to be paid and how they're calculated the cash flows are
calculated over a notional principal amount the notional amount is usually
not exchanged between counterparties it's just used as a reference from which
the size of the two payment streams can be calculated usually at the swaps
inception at least one of the cash flows is an uncertain variable such as a
floating interest rate the change in value for the uncertain cash flow will
benefit one of the two parties financially however both parties may
benefit overall if not financially by reducing financial uncertainty as
explained in my earlier video which was called should companies use derivatives
to hedge a link to that above the very first swap was negotiated in 1981 when
IBM and World Bank entered into a swap agreement since then swaps have become
one of the most heavily traded types of derivatives in the world interest rate
swaps can be most easily understood as an exchange of loans consider two
parties that have taken out loans of equal value the first is borrowed at a
fixed rate and the other at a floating rate both would like to balance their
portfolio to limit risk the two then agree to exchange their loans are swap
interest they might be doing this as a hedge to
reduce their overall interest rate risk or to speculate on the future direction
of interest rates the principal amount of the two loans is the same thus
there's no need to exchange principal leaving only the quarterly cash flows to
be exchanged the party that switches to paying a floating rate might request a
premium or offer a discount on the original fixed borrowers rate depending
on how interest rate expectations have changed since the inception of the
original loans the original fixed rate plus the premium are - the discount
would be the equivalent of a swap rate so what is the commercial need for swaps
the normal commercial operations of many businesses lead to risks associated with
interest rates or foreign exchange will take for example a US Savings and Loan
bank savings and loans accept deposits and pay a floating rate of interest on
them they then lend those deposits out as home mortgages in the United States
home mortgages are typically fixed interest rate loans as opposed to the
floating rate loans in the United Kingdom as a result a US-based savings
and loan bank can be left with fixed-rate assets and floating rate
liabilities this would lead to losses in a rising interest rate environment to
escape this interest rate risk the Savings & Loan Bank could use the swaps
market to convert either their liabilities to fixed rate or their
assets to floating rate initially interest rate swaps helped corporations
manage their interest rate risk exposures however because swaps reflect
the markets expectation for interest rates in the future
swaps also became an attractive tool for other fixed income market participants
including investors speculators and banks so what is a plain vanilla swap
the term plain vanilla when used in finance usually signifies the most basic
or standard version of a financial instrument plain vanilla is the opposite
of an exotic in ermand which is a term used to describe
a more complex security the most common type of swap is known as a plain vanilla
interest rate swap which involves one counterparty paying a fixed rate to
another counterparty while receiving a floating rate index to a reference rate
like LIBOR and return by market convention the counterparty paying the
fixed rate is the hair and the counterparty receiving the fixed rate is
the receiver see the diagram on screen right now which shows the two
counterparties and the cash flows of the swap the notional principal is an amount
used as a basis for calculations it is not actually transferred between the two
counterparties if for example the notional principal is 1 million dollars
this then allows us to calculate the amount of the payments based on the two
interest rates for each exchange the floating rate is said at the beginning
of the period and paid at the end of the period in order for swap to be valued at
zero at inception the present value of the two legs of the swap must be equal
if you calculate the net present value of the two cash flows the correct fixed
rate is the one at which the two cash flows have an equal present value okay
so let's look at an example suppose two companies ABC and XYZ agree to an
interest rate swap ABC agrees to pay a fixed rate at four percent an XYZ agrees
to pay a floating rate at LIBOR the notional principal is a hundred million
dollars payments are semiannual and the maturity is three years you can see that
swap diagram on the screen right now at the outset we don't know who will win
since we don't know the part that Libor rates will actually take in the future
we do know that there are six cash flow exchanges and that at each point ABC
will pay XYZ two million dollars assume now that the three years has passed the
table showing on screen right now shows how to swap worked out
note that the notional principal in this example $100,000,000 does not change
hands at any point between the two parties it would make no sense for them
to wire each other an identical amount of money at the outset it's just a
figure upon which the individual interest rate calculations are based
note that the interest rate swap allows the counterparties to do the same thing
as the savings and loan bank mentioned earlier that is to change borrowings
from fixed to floating or vice versa in the example ABC switched its borrowing
from floating to fixed believing interest rates would rise and XYZ
switched its borrowing from fixed to floating believing that rates would fall
so let's now learn a bit about the interest rate swaps market a significant
industry has grown in order to facilitate swap transactions initially
investment banks would match counterparties and charge them a fee
over time they moved to a model where they make markets in interest rate swaps
and would charge a spread the spread charged compensates the dealer for the
risk of counterparty default the risk of mismatched entry timing to each leg and
provides a profit dealers often have a portfolio of swaps to manage and can
find themselves exposed to the very risks their customers are trying to
avoid there are many market participants who
transact in swaps swap brokers service information
intermediaries they have a number of potential counterparties in their
contact list and stand ready to find a suitable counterparty first swap upon
demand the broker will protect the identity of the interested parties until
they have found a very likely counterparty for their services a swap
broker receives a fee from each of the counterparties swap dealers serve as
financial intermediaries and fulfill all of the roles of the swap broker but they
may also take risk positions in swap transactions by becoming an actual party
to the transaction usually the swap dealer will take a risk position in
order facilitate the trade of the initial
customer but then they'll quickly see per offset that risk in the market the
swap dealer will charge a spread as shown on the screen right now most swaps
are traded over the counter but some types of swaps are also traded on
exchanges such as the Chicago Mercantile Exchange the CBOE the Intercontinental
exchange and your eggs so who trade swaps then let's look at five different
groups number one company treasurer's companies can set up swaps to hedge
their interest rate exposure or to more closely match their assets or income
stream as explained above number two speculators swaps give fixed income
traders away to speculate on movements in interest rates while reducing the
cost of long and short positions in Treasuries instead of buying a Treasury
bond to speculate on a fall in interest rates a trader could receive fixed in a
swap which gives a similar payoff should interest rates fall but does not require
the investor to put up as much capital number three portfolio managers interest
rate swaps give fixed income portfolio managers the ability to quickly add or
reduce the duration of their portfolio they give portfolio managers a way of
adjusting interest rate exposure and offsetting the risks posed by interest
rate volatility long-dated interest rate swaps can be an effective tool in
liability driven investing allowing portfolio managers to increase the
duration of a portfolio where the aim is to match the duration of assets with
that of long term liabilities number four risk managers financial
institutions are usually involved in a huge number of transactions involving
loans derivatives contracts and other investments all of which can expose the
institution to interest rate risk this risk can be managed using swaps number
five bond issuers when corporations decide to issue bonds they usually lock
in an interest rate by entering into swap contract
that gives them time to go out and find investors for the bonds once the bonds
are sold they can exit the swap contracts the swap contracts will have
hedged the interest rate risk between the sales pitch for the bonds and the
actual sale the importance of swaps and markets currency swaps originated when
foreign exchange traders entered these agreements to work around British
controls on the movement of foreign currency the first interest rate swap
was negotiated in 1981 between the World Bank and IBM IBM at the time had large
amounts of Swiss franc and German Deutsche Mark debt, IBM and the World
Bank worked out an agreement in which the World Bank borrowed dollars in the
US market and swapped the dollar payment obligation to IBM in exchange for taking
over IBM Swiss franc and deutsche mark obligations the swap market has grown
immensely since then the notional dollar value of outstanding interest rate swaps
globally was 318 trillion dollars at the end of 2017 according to the Bank for
International Settlements. The swaps market gave rise to ISDA, the
International Swaps and Derivatives Association - the global trade association
that created the core documentation for the over-the-counter derivatives world.
I'll probably do a video on the is de Master Agreement sometime soon
swaps today are easily the largest part of the derivatives world by notional
value is outstanding so that's it you made it all the way to the end so do hit
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button comment below if there are any additional topics you'd like to see me
cover in these videos tune in tomorrow to learn about currency swaps see you
then and have a great day bye
you