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Understanding The Financial Swaps Market

Understanding The Financial Swaps Market

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Published by: tiger0007 on Feb 05, 2012
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 ==== ====The List Building Academy: Teaching The Best Strategies For Success!http://www.listbuildingconcepts.com ==== ====Exchange rate instability and the collapse of the Bretton Woods System and particularly thecontrol over the movement of the capital internationally, paved the way for the origin of thefinancial swaps market. To day swaps are at the center of the global financial revolution. Thegrowth is such that sometimes it looks like unbelievable but it is true. Though its growth willcontinue or not is doubtful. Already the shaking has started. In the "plain vanilla" dollar sector, theprofits for brokers and market makers, after costs and allocation of risk capital, are measured infewer than five basis points. This is before the regulators catch up and force disclosure and capitalhaircuts. At these spreads, the more highly paid must move on to currency swaps, tax-drivendeals, tailored structures and schlock swaps. The fact which is certain is that, although the excitement may diminish, swaps will stay. Already,swaps have had a major macro economic impact forging the linkage between the euro and thedomestic markets, flattening the cash yield curves, and reducing central bank monopoly influenceon markets. We are all swappers now. And remember the saying "beware of honey offered on asharp knife" when you are offered sweet deals. The problem in following the chaotic process ofthis very important market is quite simply that "he who knows does not speak, he who speaksdoes not know." The concept of the SWAPS The aim of a swap contract is to bind the two counter-parties to exchange two different paymentstreams over time, the payment being tied, or at least in part, to subsequent-and uncertain-marketprice developments. In most swaps so far, the prices concerned have been exchange rates orinterest rates, but they increasingly reach out to equity indices and physical commodities. All suchprices have risk characteristics in common, in quality if not degree. And for all, the allure of swapsmay be expected cost saving, yield enhancement, or hedging or speculative opportunity. Portfolio management requires financial swaps which are simple in principle, versatile in practiceyet revolutionary. A swap coupled with an existing asset or liability can radically modify effectiverisk and return. Individually and together with futures, options and other financial derivatives, theyallow yield curve and currency risks, and liquidity and geographic market considerations, all to bemanaged separately and also independently of underlying cash market stocks. Growth of the SWAP Market In the international finance market most of the new products are executed in a physical market butswap transactions are not. Participants in the swap market are many and varied in their locationcharacter and motivates in exciting swaps. However, in general the activity of the participants inthe swap market have taken on the character of a classical financial market connected to, and
integrating the underlying money, capital and foreign exchange market. Swap in their current form started in 1981 with the well-publicized currency swaps, and in thefollowing year with dollar interest rate swaps. The initial deals were characterized by the threecritical features. Barter- two counter-parties with exactly offsetting exposures were introduced by a third party. If thecredit risk were unequal, the third party- if a bank - might interpose itself or arrange for a bank todo so for a small fee.Arbitrage driven- the swap was driven by a arbitrage which gave some profit to all three parties.Generally, this was a credit arbitrage or market access arbitrage.Liability driven- almost all swaps were driven by the need to manage a debt issue on both sides. The major dramatic change has been the emergence of the large banks as aggressive marketmakers in dollar interest rate swaps. Major US banks are in the business of taking credit risk andinterest rate risk. They, therefore, do not need counter-parties to do dollar swaps. The net result isthat spreads have collapsed and volume has exploded. This means that institutional investors geta better return on their investments and international borrowers pay lower financing costs. This, inturn, result in more competitively priced goods for consumers and in enhanced returns pensioners.Swap therefore, have an effect on almost all of us yet they remain an arcane derivative riskmanagement tool, sometimes suspected of providing the international banking system with toolsrequired to bring about destruction. Although the swap market is now firmly established, there remains a wide divergence amongcurrent and potential users as to how exactly a given swap structure works, what risks are entailedwhen entering into swap transactions and precisely what "the swap market" is and, for that matteris not. The basic SWAP Structures The growth and continued success of the swap market has been due small part to the creativity ofits participants. As a result, the swaps structures currently available and the future potentialstructures which will in time become just another market "norm" are limited only by the imaginationand ingenuity of those participating in the market. Nonetheless, underlying the swap transactionsseen in the financial swaps market today are four basic structures which may now be consideredas "fundamental". These structures are (1) the Interest Rate Swap, (2) the Fixed Rate CurrencySwap, (3) the Currency Coupon Swap and (4) the Basis Rate Swap. Abey Francis, a full time blogger engaged in the areas of management and technology. Authorand Moderator of famous business management blog Management Articles and Business CaseStudies  

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