What is the purpose of swaps? | TigerDroppings.com

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ClydeFrog
Oklahoma Fan
Kansas
Member since Jul 2012
3007 posts

What is the purpose of swaps?



I'm referring to the plain vanilla type of swaps where one company pays a fixed interest rate on the principle to another company who pays a floating interest rate, like LIBOR.

Is this is a situation where one party can only profit at the other party's expense? For example, one company thinks that the floating interest rate will pay them more than they have to pay at the fixed rate over the life of the contract. It's like two companies have different ideas about which rate will be higher and they profit according to who correctly forcastes the future rates. Is that the basic idea?







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jso0003
Auburn Fan
Birmingham/Atlanta
Member since Jun 2009
4884 posts

re: What is the purpose of swaps?


Interest rate hedging

Swaps are used to gain variable rate exposure on a fixed rate, or the other way around.



This post was edited on 1/17 at 9:26 pm


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ClydeFrog
Oklahoma Fan
Kansas
Member since Jul 2012
3007 posts

re: What is the purpose of swaps?


quote:

Interest rate hedging


So one company thinks the fixed interest rate will be more favorable in the future than the floating rate and this will minimize their exposure to risk?

I understand hedging but I'm having trouble understanding why the two parties make payments to each other. My first thought of hedging is something like an oil company locking in a price of $100 per barrel because they think the future price will drop to $98 per barrel. No simultaneous payments are being made here.







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jso0003
Auburn Fan
Birmingham/Atlanta
Member since Jun 2009
4884 posts

re: What is the purpose of swaps?


You're thinking of hedging in the wrong context.

Hedging is not done because you want to bet on something going a certain direction.






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foshizzle
LSU Fan
Washington DC metro
Member since Mar 2008
30155 posts
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re: What is the purpose of swaps?


Often it is more insurance than hoping someone else is wrong.

It's hard to evaluate the worth of a swap (hell, of any financial instrument) without considering everything else you have too. Swaps are an easy way to change your exposure profile, often more so than buying/selling something else you may have.






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LSURussian
LSU Fan
Baton Rouge
Member since Feb 2005
82812 posts

re: What is the purpose of swaps?


As already discussed SWAPS are most commonly used to decrease the interest rate repricing mismatch between rate sensitive assets and rate sensitive liabilities, usually for financial institutions. This is hedging interest rate risk on a macro level.

But banks also use SWAPS to create "artificial" fixed or variable rate positions on the transaction level, or micro level.

For example, a bank may want to make a relatively large loan to an important customer and the customer may insist the loan be at a fixed rate for, say, 5 years. The bank may not be able to find fixed rate funding for 5 years to fund the loan and must fund the loan via floating rate deposits.

So, the bank can fund the loan via the variable rate deposits and offset the interest rate risk by buying a variable rate SWAP (in the same amount of the loan) with a 5 year maturity and thereby receive a variable rate income flow offsetting the variable rate expenses associated with funding the loan and paying out on the SWAP a fixed rate with a favorable spread to what it will be receiving on the fixed rate loan thus guaranteeing itself a profitable spread on that transaction over its life while negating the interest rate risk.

All this depends, of course, on the rates on the SWAP being favorable to the rate the bank can charge its borrower on the fixed rate loan.






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Doc Fenton
LSU Fan
Member since Feb 2007
51086 posts

re: What is the purpose of swaps?


quote:

Often it is more insurance than hoping someone else is wrong.


This is true. These types of instruments improve markets on a macro level in two ways: (1) by helping parties hedge risk, and (2) by adding information to the system. But I think most volume comes from (1).

And even for "directional" trades that fall into category (2), where hedge funds and proprietary trading desks try to beat the market with their own ideas, they will often need to hedge their trades with swaps so as to limit their risk to whatever their core profit trading idea really is.

And don't forget volatility/variance swaps...






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jso0003
Auburn Fan
Birmingham/Atlanta
Member since Jun 2009
4884 posts

re: What is the purpose of swaps?


The plain vanilla swaps are basically a smoothing mechanism to the macro economy.





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prplhze2000
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Member since Jan 2007
31575 posts
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re: What is the purpose of swaps?


and its something cities and parishes have no business fooling with.





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LSURussian
LSU Fan
Baton Rouge
Member since Feb 2005
82812 posts

re: What is the purpose of swaps?


quote:

and its something cities and parishes have no business fooling with.

If they know what they are doing and they are doing it to lower their interest rate risk rather than speculating on the direction of interest rate movement, why not?






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prplhze2000
LSU Fan
Parts Unknown
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re: What is the purpose of swaps?


You raise a good question. Seriously.

Come to Mississippi and you will see NONE of the city and county governments have no clue about how to use them or have any business fooling with them. Hinds County has one. Auditor states it loses money every year on the deal. Meanwhile they pay a well-connected financial advisor a bunch of money to "monitor" the swap. Its in EMMA, 2006 and 2007 series. These guys can't even read balance sheets, much less understand what an advisor is telling them.






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LSURussian
LSU Fan
Baton Rouge
Member since Feb 2005
82812 posts

re: What is the purpose of swaps?


quote:

Auditor states it loses money every year on the deal.


I don't know any details about their SWAP position but it is not unusual for a holder of a SWAP to lose money on the position.

A SWAP's proper purpose is NOT to make a profit. It is to mitigate interest rate risk which the SWAP holder has in its "on balance sheet" position.

If Hinds County has been losing money in its SWAP contract, it sounds like they purchased a variable rate swap when rates were higher. As rates have declined over the last few years they receive a lower amount of interest on their variable SWAP while continuing to pay the fixed rate they agreed to pay when they entered into the contract.

The reason they MAY have bought the SWAP is they issued some long term variable rate bonds or they issued some short term fixed rate bonds which they anticipated having to roll over (renew) for a number of years.

Either of those types of issues would have left the county exposed to interest rate risk if rates went up over the life of the bonds or until the bonds could be called.

So to lessen this risk, they bought a variable rate SWAP so if rates increased the county's increased interest expense on the bonds would be cancelled out by the increase in the variable income they would receive on the SWAP position.

Again, I don't know any details of their reason for buying the SWAP but if they did so based on my hypothesis above, the auditor should be fired if all he does is note the loss in the SWAP position if he does not explain the interest rate risk mitigation the SWAP provides.

A SWAP is an insurance policy against interest rates in the market moving against the balance sheet position of the holder of the SWAP.

Does the auditor also point out the county loses money every year on paying its casualty insurance premiums when there are no covered damages to county property for which the insurance company reimburses the county? It's the same principle as a properly used SWAP.

It may cost the county a little money but it prevents the county from losing A LOT of money.

Is it possible the auditor does not understand the purpose of SWAPS? And perhaps you, too?






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prplhze2000
LSU Fan
Parts Unknown
Member since Jan 2007
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re: What is the purpose of swaps?


I'm not disagreeing with what you wrote as you are right. However, I know the State Auditor pretty well. He had some professionals look at them. They said they were so screwed up, they didn't see how the county could make money on them. As for losing money, the county annual audit states the market value of them. You are correct, the amount of the loss fluctuated with the interest rates and as the rates dropped, so did the loss. However, the loss (on paper) is still substantial. Most of these local governments in Mississippi, when they do these deals, it is not to protect the finances of the government it is

1. to make money in professional service fees for the bond counsels and advisors as they don't have to bid them out and

2. To generate up front cash to make the budgets look better while jacking up the P&I and kicking the can down the road.

And in that order. As I said, I'm not disagreeing with one thing you wrote.






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LSURussian
LSU Fan
Baton Rouge
Member since Feb 2005
82812 posts

re: What is the purpose of swaps?


If the county bought the SWAPs for the sole purpose of speculating on future interest rates, whoever did it should be fired.

When Bill Clinton was first elected President, Bank of America anticipated that interest rates would skyrocket like rates did the last time a Dem President (Carter) was in office.

So BoA bought tens of billions of dollars of variable rate SWAPS based on pure speculation that rates would increase and not for the purpose of protecting the bank's balance sheet position.

Of course, we know that rates declined over Clinton's two terms and BoA had to take a huge loss (several billion dollars' worth) and several heads at BoA rolled when they made the announcement of the loss resulting from selling their speculative SWAP position.






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LSUAZ
LSU Fan
Member since Nov 2012
17 posts

re: What is the purpose of swaps?


Swaps are bullshyte in most cases. Unless you are using a CDS to control potential risk as far as insolvency in a company you have an interest in or missed payments... see AIG 2008 also see Greek CDS which were technically in default for non-payment and most got NADA, nothing. SWAPs - complicated BS instrument created for decent purposes but built into confusing pieces of financial jargon usually serving the seller only





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LSURussian
LSU Fan
Baton Rouge
Member since Feb 2005
82812 posts

re: What is the purpose of swaps?


It appears to me you are confusing credit default swaps with interest rate swaps.

Both types of swaps are useful as tools in decreasing two different types of risk, although the purchaser has to do due diligence on its counter party and must read the fine print carefully.






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BennyAndTheInkJets
Arkansas Fan
NYC / Orange County
Member since Nov 2010
3991 posts

re: What is the purpose of swaps?


quote:

Swaps are bullshyte in most cases. Unless you are using a CDS to control potential risk as far as insolvency in a company you have an interest in or missed payments... see AIG 2008 also see Greek CDS which were technically in default for non-payment and most got NADA, nothing. SWAPs - complicated BS instrument created for decent purposes but built into confusing pieces of financial jargon usually serving the seller only

So wait, you're saying interest rate swaps are bull shite and CDS is a good hedge? That is, and I really don't like saying this, just completely fricking wrong. When a credit event actually takes place and you go into the auction process for recovery on CDS, that is a very complicated process. Interest rate swaps are the most simple derivative in the market, and there is no such thing as a "seller" of interest rate swaps. It's just a contract between two people, one side pays a fixed rate and one side pays a floating rate.

Swaps, as Russian has tried to say, are nothing but tools to either hedge interest rate risk or speculate on interest rate risk. Banks primarily enter in the pay-fixed side as most of their assets are loans that they receive fixed payments on. Their liabilities are floating rate instruments so they cut their interest rate risk and can plan cash flows.

Swaps are mainly used in portfolios to manage duration, you can lower duration by taking the pay-fixed side or increase duration by taking the receive-fixed side. Since it's a contract and not a security, you don't have transaction costs so it's a really cost effective way to manage duration. Counterparty risk is another issue. You can also do swaps on almost every rate so you can eliminate some basis risk with trades as well.

My favorite instrument in the market is actually an option on swaps, called swaptions. Probably a different topic for a different day but those instruments are awesome ways to trade volatiliity, convexity, and even yield for a portfolio

ETA: I'm guessing you're referring to CDS as swaps. Apologies for the rudeness but please designate. There is a laundry list of different types of swaps.



This post was edited on 1/18 at 1:39 pm


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Doc Fenton
LSU Fan
Member since Feb 2007
51086 posts

re: What is the purpose of swaps?


quote:

see AIG 2008


Ironically, AIG's whole problem was that they didn't buy the swaps they should have.

Their FP division had a great business going selling CDS protection to people, but they neglected to hedge their business against risk from an increase in volatility.

They probably could have weathered the storm without a bailout if it weren't for all the margin calls on the CDS contracts they wrote to various buyers. If they would have bought some insurance in the form of variance swaps, they could have been okay.

But they didn't know what they were doing, because they were an insurance company (under siege from the Eliot Spitzers of the world, by the way) trying to branch out into sophisticated financial products. From what I hear, they got a bunch of hired guns to run that part of the business, without having any idea how to implement a competent risk management program. The hired guns had free rein to take risks without following quality control, which is fine for an individual, but gets dangerous for the whole corporation.






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BennyAndTheInkJets
Arkansas Fan
NYC / Orange County
Member since Nov 2010
3991 posts

re: What is the purpose of swaps?


quote:

From what I hear, they got a bunch of hired guns to run that part of the business, without having any idea how to implement a competent risk management program. The hired guns had free rein to take risks without following quality control, which is fine for an individual, but gets dangerous for the whole corporation.

In their defense, which they have very little, not many firms on the street were doing competent risk management on derivatives and structured products at the time. All AIG knew is "We write CDS on these AAA rated MBS, where default rates are insanely low. We can just keep writing these and picking up income that will more than offset any 100-200bp spike in default rates." Default rates spiked WAY more than that and they were left to find recovery values in products that had basically none.






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