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A swap is another forward-based derivative that obligates two counterparties to exchange a series of cash flows at specified settlement dates in the future (Siems, 1997 ). There are two principal types of swaps: interest-rate swaps and currency swaps. Today interest-rate swaps account for the majority of swap activity. Swaps are traded on a bilateral basis and consist of customized, privately negotiated derivatives, which are known generically as over-the-counter (OTC)derivatives. Options are a type of derivative instrument. They are used for hedging interest-rate risk, the risk of foreign exchange rate movements, and stock market risk. Further, as discussed in Module 6, the relationship between short- and long-term yields captured by the yield curve has been disappearing since the 1990s, please see Federal Deposit Insurance Corporation (FDIC), FYI, 2006. Due to the falling term premium, there has been a flattening of the yield curve in recent years (particularly since 2004). As result of this development, banks are not able to have perfect foresight as to how bank net interest margins (the difference between the interest on the deposits paid by the banks and interest received from long term loans) and thus earnings will fluctuate (please see FDIC, FYI, 2006, cited in footnote 4). Banks are finding that their net interest margins have been squeezed by the flat yield curve. As a consequence, they are reducing their reliance on products giving interest income and diversifying their sources of non-interest income, like fee based products and off-balance sheet activities , for example, securitizing of loans into mortgage backed securities. Financial Institutions are also accessing alternative funding sources that insulate them from interest rate shifts, since traditional deposits are more exposed to the risk of short-term interest rate volatility. One such alternative
source of funding is the commercial paper market. Many of these developments have been facilitated by the use of information technologies. Financial innovations as a response to supply-side changes Improvements in computer and telecommunications technology, (information technology or IT), have been the most important source of changes in supply conditions that stimulated financial innovations, These resulted in the development of new products, services and processes. The financial industry is one of the most technology-driven information-based businesses. IT had the following major effects: Product innovations can be exemplified by new derivative products, new corporate securities and new forms of pooled investment products. Examples of process innovations are new methods of distributing securities and of processing or pricing transactions. Process and product innovations are often linked (see Tapscott, 2003, for details). IT has a great potential for altering the supply conditions in the financial market place, some of which are discussed below. On the relationship between technology and financial innovations, White remarks