Abstract: Bank executives are looking to derivative financial product markets for means to better manage their balance sheets. In particular, swaps--with their widespread applications-have attracted the attention of bankers, regulators, and accountants. Since its inception in the 1980s, the derivatives market has had an air of mystique. This is due in part to the shrouded nature of the market vis-a-vis public bond markets, the sophistication of early users, and the seemingly complex cross-border structures used in the market's fledgling days. Since then, the derivatives market has evolved from a highly fragmented, illiquid arena to an efficient global market with numerous players. While derivative product variations now encompass interest rates, foreign exchange, equities, and commodities in most major and many minor markets, the products basically fall into three categories: swaps, options, and futures. While their breadth and variety can be overwhelming at first glance, the market enables educated users to hedge virtually any type of balance sheet risk exposure. Swap market growth. Swaps have become an accepted hedging and investment tool for many banks, from money centers to smaller institutions, as well as nonbanking companies. This acceptance is evidenced by the sharp growth in the market volume of interest-rate swaps outstanding, which reached $1.5 trillion in 1991. Today, swaps are being structured to match virtually any customer need or exposure. While the largest volume transacted is in one-to-three year maturities, a liquid market exists for maturities of up to 10 years, and 15-to-20year maturities are available from some dealers. A variety of floating indices are used in the swaps market, including LIBOR (London interbank offered rate), commercial paper, Fed funds, prime, and Treasury bills. The number of active market makers has grown from a core group of large commercial banks to include major European and Japanese banks, investment banks, and subsidiaries of nonbank financial institutions. Activity has grown to the point where market makers usually do not charge fees for their services, instead making their profit from the spread between the bid and offered prices on swaps. While both sides of a swap used to have to be negotiated directly, the market is broad enough now that market makers can arrange one side for a user, such as a bank, and warehouse the transaction to be matched to a compatible contract for another user. Swap basics. Interest-rate swaps are the most widespread of the derivatives traded over the counter. In its simplest form, a swap is an agreement between two counterparties to exchange future cashflows. This enables an end user to transform an existing asset or liability from one basis to another without affecting the balance sheet itself. For example, a bank with floating-rate funding can synthetically create fixed-rate funding through a basic interest-rate swap. More specifically, the bank (the payer) makes a stream of fixed-rate payments to a swap market maker on a series of payment dates from the value date (the swap's effective date) to the swap's maturity date. In return, the bank will receive a series of floating-rate payments based on a floating reference rate, such as LIBOR. These fixed and floating payments are calculated using a principal amount. Unlike an onbalance-sheet deposit transaction, this simple interest-rate swap transaction will not entail the payment of the principal amount; only the interest cashflows based on the notional principal amount are to be exchanged. Yet the on-balance-sheet floating-rate deposit, combined with the floating-to-fixed derivative agreement, effectively transforms the deposit to a fixed rate. As both counterparties (the bank and the swap market maker) are obligated to perform payments under the contracted swap, the two swap players will have contingent credit exposure to each other. …
Publication Year: 1992
Publication Date: 1992-12-01
Language: en
Type: article
Access and Citation
AI Researcher Chatbot
Get quick answers to your questions about the article from our AI researcher chatbot