Forward, Futures, and Swaps
What is a Currency Swap?
A currency swap involves exchanging principal and interest payments in one currency for principal and interest payments in another currency.
Describe what it means to have a settlement with a forward contract.
A forward contract is usually settled directly between two counter parties when the contract expires -Each party daces counter party risk.
Describe what it means to have a settlement with a futures contract.
A futures contract is settled daily by each counter party settling with a clearinghouse rather than each other -Clearinghouse assumes the risk of default -Clearinghouse requires protection (margin accounts and marking to market)
What is credit risk important to?
Credit risk is more important for currency swaps than for interest rate swaps because there is an exchange for notional at the end. Interest rate swaps don't matter because it is all the same currency.
What do currency swaps effectively do?
Currency swaps effectively transform borrowing in one currency to borrowing in another currency
What are common swaps?
Currency, interest rate, credit and total returns
What is a notional amount?
Face value of underlying loan
How does credit risk apply to a currency swap?
In the currency swap example, the value of the swap changed when the exchange rate changed, giving the swap a negative value for one counter party
What is an equity swap?
Is called for the exchange of cash flows based on 1. the variable-debt rate (LIBOR) and 2. the return on an equity index (e.g. S&P 500)
What does a CDS allow?
It allows lenders to buy protection against losses in cases where the borrower defaults on debt -This should increase the creditworthiness of a loan because the issuer of the CDS must pay the CDS holder in case of default
What is a forward contract?
It is an arrangement to buy (or deliver) a specified quantity of an underlying asset at a specified date at a specified price
What are the terms of a forward contract?
It is an enforceable legal obligation to exchange an asset at a pre-determined time in the future at a price agreed upon today.
What is a credit default swap?
It is in effect an insurance policy on the default risk of a bond or loan
What is a future contract?
It is similar to a forward, but gains and losses are settled daily. It reduces counter-party risk.
What risk could arise when working with different currencies?
Suppose a corporation receives revenues in AUD but incurs costs in JPY-This firm could enter into a series of forward contracts to hedge its FX exposure over the next t years, however, forward contracts may not be available, or they might be to costly.
What do swaps do?
Swaps enable one party to exchange the returns of one asset for another with a counterparty. -Swaps are zero-sum games
Why use Currency Swaps?
TO MANAGE RISK
Ignoring credit risk, the value of a currency swap is given by?
Value of domestic bond - (Value of foreign bond)(Spot exchange rate) Value received - Value Paid
What is a convenience yield?
When the underlying asset is a stock that pays a dividend just prior to maturity. The convenience yield may be either positive or negative.
Why do swaps make sense?
some companies may have a comparative advantage when borrowing in fixed- rate markets, whereas other companies may have a comparative advantage when borrowing in floating-rate markets
What does an equity swap allow?
-It allows an investor to retain legal ownership rights (e.g. voting) while hedging economic exposure -It allows an investor to obtain economic exposure to an asset with minimum cash outlay
What does a forward contract specify?
-Underlying asset -Expiration date -Settlement price -Settlement terms- cash vs. actual delivery
What is credit risk?
A party (or dealer) in a swap is exposed to credit risk of the counter party -if the counterparty defaults, the you don't get paid
A Company may choose to go to the market where it has a comparative advantage, even though it wants a different type of loan. A swap can then be used for what?
A swap can then be used to transform the loan type.