CH07sguide - 7 FinancialSwaps ChapterObjectives 1 To...

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Chapter Objectives 1. To describe the origins of the swap market and its growth. 2. To discuss two major types of financial swaps--interest rate swaps and currency swaps. 3. To compute the appropriate payments and receipts associated with a given interest- rate or currency swap. 4. To explain how interest-rate and currency swaps can be used to reduce financing costs and currency risk. Chapter Outline I. The Emergence of the Swap Market A. A swap is an agreement between two parties, called counterparties, who exchange sets of cash flows over a period of time in the future. i. When exchange rate and/or interest rates fluctuate wildly, the forward market and money market do not function correctly. In such cases, swap arrangements may be used. B. Swaps are an outgrowth of parallel and back-to-back loans. i. Parallel loan refers to a loan that involves an exchange of currencies between four parties with a promise to re-exchange the currencies at a predetermined exchange rate on a specified future date. ii. Back-to-back loan refers to a loan that involves an exchange of currencies between two parties with a promise to re-exchange the Financial Swaps      86 7 Financial Swaps
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currencies at a predetermined exchange rate on a specified future date. iii. Both types of loan, parallel and back-to-back, avoid foreign exchange risk because each loan is made and repaid in one currency. iv. Three problems limit the usefulness of parallel and back-to-back loans: 1. It is difficult to find counterparties with matching needs. 2. One party is still obligated to comply with such an agreement even if another party fails to comply with the agreement. 3. The loans typically appear on the books of the participating entities. v. Currency swaps overcome the problems of parallel and back-to- back loans. 1. The problems of matching needs are reduced because currency swaps are arranged by swap dealers and brokers. 2. To avoid risk from default, the right of offset is part of the currency swap agreement. 3. For swaps, the principal amounts do not appear on the participants’ books. II. The Growth of the Swap Market A. The first swap was arranged by the Salomon Brothers on August 1981 and had the World Bank and IBM as counterparties. B. It was a small step to move from currency swaps to interest rate swaps and the first such swap happened in London in 1981. C. Chase Manhattan Bank introduced the first commodity swap in 1986. D. Bankers Trust introduced the first equity swap in 1989. i. These swaps are subsets of a new type of instruments known as synthetic equity. E. By the end of 2001, the total swap market was approximately $62 trillion. i. 93 percent of these swaps were interest rate swaps. ii. 7 percent of these swaps were currency swaps. 1. U.S. dollars account for 30%, the Japanese yen, the euro, the British pound, and the Swiss franc account for most of the remaining 70%.
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