Swaps

When people think of the biggest asset classes in financial markets, they may think of the stock market initially, or the bond market, which is considerably larger than the stock market. Those who are familiar with forex markets will know that this market is bigger than the stock market and the bond market put together, but there is another market that is bigger than anything else out there, valued in the hundreds of trillions of dollars.

The public at large and even the vast majority of individual investors aren’t that familiar with the swap market, other than perhaps hearing that some of these trades gone bad has hurt or even brought down some very big financial institutions of late. These deals, called credit default swaps, only represent a fairly small portion of the overall swap market, and many other things are swapped so to speak in derivative contracts.

The reason why swaps are termed to be derivatives is because, like other forms of derivatives like futures and options, their valuation is based upon the value of other assets or determining factors, such as interest rates, currency rates, default rates, commodity prices, equity prices, and so on.

Swaps are not traded on exchanges, but instead are deals that are put together by firms, institutions, or governments that wish to exchange one risk for another. While these swaps are still traded on public markets, in this case what is termed the over the counter market, and be bought and sold by anyone, swaps are almost always traded by these larger traders and not by the public.

This is one of the reasons why the public knows so little about the swap market, how swaps work, and even why these markets exist, because they really don’t have a need to be aware of swaps deals, at least directly.

Why Swaps Markets Matter

The swaps markets do influence the economy a great deal though, as you might imagine they would with so much money on the line. At any given time, there is several times the world’s GDP out there in terms of notional value at least.

Notional value denotes the value of the underlying assets in a trade, and while it’s not like there is the potential for the market to lose half a quadrillion dollars or something if the swaps market tanks, it is still important to look at notional value in order to get a good grasp of the scope of the market that a financial contract serves.

A lot of the swap market consists of interest rate swaps, where it is only the differences in interest rates that are exposed to the market, not the principal amounts. So if we look at a certain amount of bonds that have their interest rates swapped for instance, so many trillions worth, the risk with interest rate swaps with them and the risks of the bonds defaulting are two completely different risks.

There is still an interplay between the two, and bonds for instance are certainly affected by interest rates, as this is what drives their price. So these huge notional amounts do mean something as far as what is being hedged or speculated on, and the sheer size of the notional amounts involved in swaps does tell us that this market is extremely broad and extremely large, involving a great deal of our money supply.

Money supply is almost all created by the market, from borrowing of various sorts, and if something is fundamental to that, as the swap market clearly is, then in spite of people really never engaging in swap contracts, they can have a big influence in people’s lives, due to the way that these contracts function in the economy.

In a real sense, prosperity is almost all borrowed so to speak, so the flow of this capital does matter, and swaps concern themselves with the efficient flow of capital, from those less prepared to bear the risks of it to those more willing or better equipped to do so. That’s what swaps facilitate essentially.

Interest Rate Swaps

The biggest type of swaps by far, in terms of overall value, is interest rate swaps. There are a lot of different types of interest rate swaps, and this is all completely customizable according to the needs of the parties originating the contracts, but they mostly address swapping fixed rates for variable rates.

Many people have had the experience of deciding between fixed or variable rates when they get a loan or mortgage, and will have at least some idea that the risks are different for each.

Independent of these risks though, some people may be better suited to a fixed rate, to benefit from the stability that this offers, and it may be in their best interest to pay the risk premium involved.

There is still a risk of sorts with fixed rates though, which is that it will turn out that a floating rate would have been the better choice. If rates go down for instance during the life of the debt, one can end up paying too much in interest.

Variable or floating rates have risks associated with them as well, and you can not only end up paying more interest with them if the rates go up too much, you may also risk not being able to make the payments if the rates go high enough.

Lenders also face similar risks, and some will be in a better position to handle one type of risk over another when it comes to the type of interest payments they receive. This may have them wanting to trade these income streams of one type with another institution, for instance by swapping an income stream based upon variable rates for one that is fixed.

This allows us to borrow more efficiently when it comes time to our looking to get a loan, and also allows lenders to give us the option to choose either, since they aren’t worried about which one we select because they can swap the income streams with others as they see fit.

Subordinated Risk Swaps

Subordinated risk swaps involve transferring various types of business risks from one party to another, and this functions as a type of insurance for financial institutions.

These types of swaps may involve a variety of types of risks being transferred by way of swaps contracts, and it is the risk itself that is being swapped, for a premium. This may include things like credit risk, management risk, legal risk, or other risks that the parties agree to exchange.

The most prominent type of swap in this category is credit default swaps, where one party agrees to indemnify the other’s credit defaults. This normally all occurs without a lot of fanfare unless we see a situation where there is a massive amount of credit defaults, like we saw with the mortgage crisis of 2007.

This brought about massive losses, in the hundreds of billions of dollars, and someone had to make good on these losses. Institutions that took on a lot of this risk took a big blow, including requiring massive government bailouts to stay in business, or they simply went out of business.

Credit default swaps differ from insurance due to the fact that credit default swaps do not require an insurable interest. With insurance, the loss has to be direct to be insurable, where with credit default swaps, anyone can take on this risk.

Having these contracts traded in the market by third parties does improve the efficiency of the market to be sure, although those who take massive positions in it do need to be diligent in order to keep their exposure manageable in the face of systemic risk. This is not always the case in practice, and this is one of the reasons why free markets cannot always police themselves sufficiently without regulation.

Other Types of Swaps

The currency swap market is another large one, where institutions swap cash flows in one currency for another. This is similar to interest rate swaps, only it isn’t the type of interest payment that is swapped, it’s the type of currency that the payments are made in.

While one may hedge this in the foreign exchange market, it is often more efficient for institutions to simply swap the payments, where one may be more suited to accept payments in a particular currency than another.

Commodities are also sometimes swapped, in spite of the futures market. This involves agreements to provide a certain commodity at a certain price over a specified period of time. Most commodity swaps involve crude oil due to its particular volatility.

Equities are also swapped, where the risk involved in holding shares is transferred to another party more willing to accept the risk, in exchange for a cash payment at a certain rate. This allows for the equities to be held while transferring the risk, rather than having to liquidate them.

Entire portfolios can be hedged this way by way of a total return swap, which may involve an assortment of various assets. The total return of the portfolio is swapped for a specified payment, by another party who assumes the risk.

There are a variety of other types of financial swaps involving an exchange of a certain type of payment for another, where there is more risk involved in one side and the other party receives a premium for taking on the additional risk.

While many people think swaps to be somewhat undesirable, they do play an important role in financial markets and in the economy as a whole, and do lead to a more efficient allocation of risk.

Swaps therefore do lead to an increased ability to manage risk rather than making risk less manageable. Of course this does not substitute for sound risk management though, and while reducing risk can sometimes encourage one to take on more risk overall, this always does need to be tempered by good judgement.