Certificate in Derivatives M arket Strategies

MODULE 4: OTC DERIVATIVES

Lesson 3 Introduction to Swaps

Introduction
Overview of the Swap Market
What Is a Swap?
Role of the Swap Dealer
History of Swaps
OTC Derivatives Market Reform
Regulatory Framework for OTC Derivatives in India
Summary
CERTIFICATE IN DERIVATIVES MARKET STRATEGIES

KEY TERMS

Commodity swap Interest rate swap

Credit default swap (CDS) Plain vanilla interest rate swap
Credit derivatives Swap
Currency swap Swap dealer
Equity swap Warehousing
Certificate in Derivatives M arket Strategies

MODULE 4

Lesson 3 Introduction to Swaps

LEARNING OBJECTIVES
By the end of this lesson, you should be able to:
1. Describe what a swap is and the market that it trades in.
2. Explain why swaps are used.
3. Differentiate between swaps and forward contracts.
4. Explain the role of a swap dealer.
5. Describe the four areas of focus of the OTC derivatives market reform.

Introduction
Swaps can be thought of as a series of forward agreements, difference being the calculation of the net
swap payment is a little more complicated than it is with regular forward agreements. This lesson covers
the basics of a swap, its structure, payment mechanics and the role of the swap dealer in between the
counterparties.

Overview of the Swap Market

Since the early 1980s, interest in products offered in the over‑the‑counter derivative markets has
increased dramatically. Once considered highly specialised and custom‑made to fulfill specific needs,
these products have become standardised and more common with a growing number of dealers creating
markets for these derivatives by continually offering to buy and sell them. This increased liquidity, along
with competition among the various dealers, has made these products more appealing to firms that
had been previously reluctant to use them. Among the markets for the various derivative products, the
swap market is the one that has evolved most rapidly. Swaps are now used by financial corporations,
industrial corporations, banks, insurance companies, world organisations and sovereign governments.
They are used to reduce the cost of capital, exploit economies of scale, manage risks, arbitrage the world’s
capital markets, enter new markets, and create synthetic instruments, which are financial instruments or
portfolios of financial instruments that have identical cash flows or profit/loss characteristics of another
financial instrument or portfolio.

4 • 3 • 1
CERTIFICATE IN DERIVATIVES MARKET STRATEGIES | MODULE 4

What Is a Swap?
A swap is a particular type of OTC forward contract. As we discussed in Module 2, a standard forward
contract involves delivery and payment of a particular asset at an upfront agreed‑upon price at a
predetermined time in the future. If the contract trades on an exchange, it is referred to as a futures
contract; if it trades OTC, it is called a forward agreement.
We also discussed that some forwards are cash settled. In other words, rather than an exchange of a
physical asset for payment, all that occurs at expiration is that the losing party makes a payment to the
winning party based on the difference between the upfront agreed‑upon price and the current market
price of the asset upon which the contract is based.
Most swaps are merely cash‑settled forward agreements, but with a few slight twists. First, instead of one
payment date, as with a standard forward agreement, there is a series of predetermined payment dates. In
this sense, swaps can be thought of as a series of forward agreements.
Second, while most swaps involve a payment from loser to winner on the payment date(s), the method of
calculating the net swap payment is a little more complicated than it is with regular forward agreements.
We will explain this shortly.
The most common type of swap is one that is based on interest rates. An interest rate swap involves
an exchange of cash flows between counterparties on a series of dates that are predetermined when
the agreement is initiated. In the most basic type of interest rate swap (referred to as a plain vanilla
interest rate swap), one party agrees to pay to the other party cash flows equal to interest calculated at a
predetermined fixed rate on a certain principal amount. In exchange, the other party agrees to pay interest
calculated at a floating rate on the same principal amount.
One reason to enter into an interest rate swap agreement is if a participant has a floating‑rate loan but,
due to concerns that the floating rate may rise, wants to convert that obligation to a fixed‑rate loan. This
person could do so by finding a counterparty with the opposite situation (looking to change a fixed‑rate
loan into a floating‑rate loan due to expectations that rates may decline). By swapping their respective
payments, they in effect change their respective loans from floating to fixed and from fixed to floating.
Figure 3.1 illustrates a simple plain vanilla interest rate swap.

FIGURE 3.1 PLAIN VANILLA INTEREST RATE SWAP

Floating-Rate Payments
Counterparty A Counterparty B
Fixed-Rate Payments

While Figure 3.1 shows cash flows being swapped, what is actually being exchanged, in reality, is the net
difference between the fixed‑rate and floating‑rate cash flows. Since the floating rate changes through the
life of the swap with fluctuations in market rates, the net amount exchanged between the two parties also
changes. If market rates rise, the party contracted to pay the floating rate will be the loser and will have to
make increased net payments to the party contracted to make the fixed payment, who is the winner. This
is exactly what happens in a normal cash‑settled forward agreement. The losing party makes payments to
the winning party based on the difference between current prices and the initial price. Interest rate swaps
will be covered in detail in lesson 4.

4 • 3 • 2
 INTRODUCTION TO SWAPS

Another popular type of swap is a currency swap. It is similar to an interest rate swap with a few
differences. First, the counterparties exchange cash flows that are denominated in different currencies.
Second, in addition to the exchange of fixed- for floating‑rate payments, currency swaps can also be
designed so that two fixed‑rate payments are exchanged or two floating rates are exchanged. Finally,
currency swaps often involve the exchange of principal at the contract’s onset and then a return of the
principal at maturity. Interest rate swaps do not involve an exchange of principal, just net cash flows.
Currency swaps will be explained in detail in Lesson 5.
The fastest‑growing type of swap is the credit default swap, which is a type of credit derivative. A rapidly
growing segment in the marketplace, credit derivatives are financial instruments that derive their value
from an underlying credit asset or pool of credit assets, such as bonds or mortgages, and are designed to
transfer and manage credit risk. A credit default swap (CDS) is the exchange of two cash flows – a fee
payment and a conditional payment – which occurs only if certain circumstances are met. A CDS is credit
insurance that transfers the credit risk of fixed‑income securities from one party to another. The CDS buyer
receives protection and the CDS seller guarantees payment if negative credit events occur. The cash flow
and payment mechanics are the same as the plain vanilla interest rate swap mentioned earlier, except that
payment from the credit swap seller is contingent upon a credit event happening. Credit default swaps will
be explained in detail in Lesson 6.
Other types of swaps that will be covered in this module are equity swaps and commodity swaps. Both
of these swaps will be discussed in Lesson 7.

Role of the Swap Dealer

Without a financial intermediary, it would be extremely difficult for two counterparties to find each other
and design a product to satisfy their objectives. The role of the swap dealer is to facilitate the entire
process by finding and bringing together the two sides and tailoring a product to meet the specific needs
of the two end users. The dealer simplifies the whole process by acting as a counterparty for each of the
two end users and entering into separate agreements with each one. For the services provided, the dealer
charges a fee which usually takes the form of a bid‑ask spread on the fixed periodic payments.
Figure 3.2 depicts a plain vanilla interest rate swap engineered with the help of a dealer. For both end
users, the counterparty to the swap is the dealer. For designing the swap and matching up the two end
users, the dealer will earn a spread. If Party A is paying a fixed rate of 4% to the dealer (in exchange for a
floating‑rate payment), the dealer will then pay a fixed rate of 3.8%, for example, to Party B. The dealer
will earn a spread of 0.2%.

FIGURE 3.2 PLAIN VANILLA INTEREST RATE SWAP ARRANGED BY A SWAP DEALER

LIBOR LIBOR
Counterparty A Swap Dealer Counterparty B
4% 3.8%

TRAINING & CERTIFICATION 4 • 3 • 3

CERTIFICATE IN DERIVATIVES MARKET STRATEGIES | MODULE 4

In practice, it is very unlikely that the swap dealer would enter into agreements with both counterparties
concurrently. In fact, once the dealer gets into an agreement with Party A, it may take some time to find
and arrange an offsetting agreement with Party B. In such cases, the dealer has to warehouse the swap
and hedge its interest rate exposure until a suitable counterparty can be found.

History of Swaps
The first currency swap occurred in 1979 and was engineered in London, England. During the next couple
of years, the market remained small. It was mainly a brokered market with financial institutions finding
and serving clients with opposite needs. For example, a party that wished to convert a fixed‑rate to a
floating‑rate obligation could employ a swap dealer to attain its goal. In the process, the dealer would find
a counterparty that wished to convert a floating‑rate into a fixed‑rate obligation and would bring the two
interested parties together. The broker would earn a fee for this service.
What really boosted the market was a landmark currency swap between IBM and the World Bank in 1981.
After that, the swap market grew dramatically. It was a short time before interest rate swaps appeared
and started gaining in popularity, particularly in the United States where the products were quickly
adopted by major U.S. firms. Understanding the potential, brokers began to assume the role of dealers
by making the market and taking one side of the swap. They would quote a bid rate and an ask rate, and
they would earn a profit on the spread. The swap brokers would be exposed to some risk, but this could be
hedged in the futures and options or the Treasury securities markets. The result was a tremendous increase
in market liquidity and a standardisation of many of the products offered. In the 1990s, OTC derivatives
on fixed‑income securities accelerated with the creation of credit default swaps, which are primarily
responsible for the current explosive growth in credit derivatives and the global derivatives market in
general.
In 1984, work was initiated on standardising swap documentation by leading dealers (commercial and
investment banks). In 1985, the group formed the International Swaps and Derivatives Association (ISDA)
and published its first standardised swap code. The code was revised in 1986 and again in 1987 when the
publication of standard form agreements took place. The first edition of the ISDA Master Agreement was
published in 1992. A second edition was published in 2002 and is still the current version in use today.
Standardisation of the necessary documentation drastically reduced the cost and the time requirements
of engineering a swap. The notional principal of interest and currency swaps grew from about $5 billion in
1982 to more than $447 trillion by the end of June 2014.

OTC Derivatives Market Reform

Following the U.S. sub‑prime crisis and the far‑reaching credit meltdown of 2007-2008, regulators and
market observers from around the world unanimously agreed that segments of the OTC derivatives
market (including swaps) played a role in the widespread and rapid rise of counterparty and liquidity risks
during the crisis. The difficulty in correctly assessing in a timely manner the risks associated with large and
concentrated derivative positions in the hands of a few systemically relevant and interconnected financial
institutions created significant financial stress and market disruptions.

4 • 3 • 4
 INTRODUCTION TO SWAPS

The financial crisis impelled finance ministers and central bank governors of the Group of Twenty countries
(G20) to propose reforms to the OTC derivatives market. In the following extract from the statement
issued following the 2009 G20 meeting in Pittsburgh, the G20 leaders broke down their plan of action for
“improving over‑the‑counter derivatives markets”:
“All standardised OTC derivative contracts should be traded on exchanges or electronic trading
platforms, where appropriate, and cleared through central counterparties by end-2012 at the latest.
OTC derivative contracts should be reported to trade repositories. Non‑centrally cleared contracts
should be subject to higher capital requirements. We ask the FSB and its relevant members to assess
regularly implementation and whether it is sufficient to improve transparency in the derivatives
markets, mitigate systemic risk, and protect against market abuse.” 1
Table 3.1 summarises the four areas of focus of international regulatory reforms recommended by the G20
leaders, all of which are in various stages of development in each of the G20 nations.

TABLE 3.1 OUTLINE OF THE OTC DERIVATIVES MARKET REFORM

1. All standardised OTC In addition to the ongoing industry effort to increase

derivative contracts should
be traded on exchanges or
electronic trading platforms,
where appropriate.
the degree of standardisation in OTC derivatives
contracts, domestic authorities are in the midst
of finalising regulations mandating the migration
of standardised OTC derivatives transactions to
electronic trading platforms.

2. All standardised OTC
derivative contracts should
be cleared through central
counterparties.
While the original deadline (2012) proved to be too
challenging to meet for most countries, financial
institutions involved in derivatives trading are
currently getting access to domestic or global central
counterparties (CCPs). As of June 2017, 11 of the 24
Financial Stability Board (FSB) jurisdictions have
central clearing requirements in place*.

3. All OTC derivative contracts The ongoing development of trade repositories to

should be reported to trade
repositories.
which market participants will have appropriate
accesses is a key element in the increased
transparency sought by the OTC market reforms.
As of June 2017, 19 of the 24 FSB jurisdictions have
comprehensive trade reporting requirements in place.

4. Non centrally cleared For all non-centrally cleared derivatives contracts,

derivative contracts (NCCD) counterparty risk management best practices will
should be subject to higher require higher capital requirements. The vast majority
capital requirements. of jurisdictions have set higher capital requirements
for NCCDs.

* Financial Stability Board – OTC Derivatives Market Reform: Progress Report on Implementation:
http://www.fsb.org/2017/06/otc-derivatives-market-reforms-twelfth-progress-report-on-implementation/

G20 Leaders’ Statement, page 9 – September 25, 2009 (Pittsburgh, Pennsylvania) – https://www.treasury.gov/resource-
1

center/international/g7-g20/Documents/pittsburgh_summit_leaders_statement_250909.pdf

TRAINING & CERTIFICATION 4 • 3 • 5

CERTIFICATE IN DERIVATIVES MARKET STRATEGIES | MODULE 4

The 2009 G20 statement extract also refers to the Financial Stability Board (the FSB). The objective
of the FSB is “to coordinate at the international level the work of national financial authorities”. As an
international body set up at the initiative of the G20, one of its mandates is to issue semi‑annual progress
reports on the implementation of OTC derivatives market reforms.

Regulatory Framework for OTC Derivatives in India

Unlike most other jurisdictions in the world, the OTC derivative market in India has evolved within a
regulated space. The responsibility for the regulation of all interest rate, forex and credit derivatives,
including OTC derivatives, rests with the Reserve Bank of India (RBI).
India is party to the G-20 reform efforts and, in some respects because of the carefulness of the regulatory
structure from the onset of OTC derivatives trading, is well positioned to meet the evolving standards.
The major elements of the RBI regulatory framework for OTC derivatives include a broad specification
of products to be permitted, nature of participants in the markets, distinct responsibilities for market
makers and users for all OTC derivatives, effective reporting systems for capturing systemic information,
governance and oversight and focus on developing market infrastructure for post-trade clearing and
settlement.
The Clearing Corporation of India (CCIL) has for several years now cleared, settled and functioned as the
central counterparty to all trades in both spot and forward markets in both debt and foreign exchange.
In 2015, the CCIL developed the Anonymous IRS Dealing System, or ASTROID to specifically handle
trading in Rupee OTC interest rate derivatives. The trades dealt in ASTROID are eligible for CCIL’s clearing
and settlement services. The guarantee offered by CCIL on some OTC products has gone a long way
in reducing the capital requirements for the banks. In 2016, the RBI selected the CCIL to be the trade
repository for OTC interest rate and foreign exchange contracts.
One of the unique aspects of the regulation in India is that the RBI permits two general types of
participants in the OTC derivatives market: market makers and users. Market making is generally restricted
to banks and primary dealers, although subject to the approval of their respective regulators in some
cases insurance and mutual fund companies can also act as market makers. Market makers can use OTC
derivatives for their own balance sheet management and as well for market making.
Users, which would include listed corporations, mutual funds, and insurance companies, are permitted
to transact in derivatives essentially only to hedge or transform an existing risk exposure. This stipulation
is essentially to restrict speculative trading in derivatives by the real sector, whose primary economic
interest in undertaking derivative transactions is to hedge their exposures.
Another aspect of OTC trading in India is that for an OTC transaction to be legally valid, one of the parties
to the agreement has to be an RBI regulated entity, such as a scheduled commercial bank (SCB), primary
dealer or an all-India financial institution.
The RBI determines the types of OTC derivative instruments that are allowed. Currently the market
consists of interest rate swaps (IRS), interest rate options (caps, floors and collars)2, forward rate
agreements (FRAs), currency forwards, options and swaps, and more recently credit default swaps (CDSs).

Interest rate options were approved for trading by the RBI in January 2017.
2

4 • 3 • 6
 INTRODUCTION TO SWAPS

Summary
Now that you have completed this lesson, you should be able to:
1. Describe what a swap is and the market that it trades in.

» A swap is a series of forward agreements typically settled in cash.

» Swaps can be based on interest rates, currencies, equity or commodity prices and credit default
events.

2. Explain why swaps are used.

» In the case of interest rate swaps, it is an opportunity to secure cheaper financing than it would be
without a swap.

» In the case of a currency swap, it is also an opportunity to secure cheaper financing. It is similar
to an interest rate swap, with the difference that the counterparties exchange cash flows that are
denominated in different currencies.

» In the case of a credit default swap, it is insurance against a negative credit event.

3. Differentiate between swaps and forward contracts.

» A swap has a series of predetermined payment dates whereas a forward contract has one.

4. Explain the role of a swap dealer.

» A swap dealer brings together two counterparties and tailors a product to meet the specific needs
of both.

» The dealer acts as a counterparty for each of the two end users and enters into separate
agreements with each one.

5. Describe the four areas of focus of the OTC derivatives market reform.

» All standardised OTC derivative contracts should be traded on exchanges or electronic trading
platforms, where appropriate.

» All standardised OTC derivative contracts should be cleared through central counterparties.

» All OTC derivative contracts should be reported to trade repositories.

» Non-centrally cleared derivative contracts should be subject to higher capital requirements.

TRAINING & CERTIFICATION 4 • 3 • 7