What is the purpose of swaps?

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Interest rate hedging

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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.

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

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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...

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

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Auditor states it loses money every year on the deal.

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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?

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.

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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see AIG 2008

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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.