Development of the Swaps Development of the Swaps MarketMarket

Joseph Di PeriStephen Asai

OutlineOutlineDiscussion of currency swapBrief review of an interest rate

swapGrowth of secondary marketOther types of swapsFinancial intermediariesCredit default swaps

Introduction to currency Introduction to currency swapswap

How they work◦Plain vanilla currency swap

First swap conductedFirst swap conductedWorld Bank and IBM

◦Occurred in 1981◦Currency swap through Salomon

Brothers◦German, Swiss, and U.S markets

impact◦March 1980, the exchange rate was

1.93 DM/US dollar. August 1981, the rate was 2.52 DM/US dollar. 100 DM coupon payments were $51.81 and

after the exchange rate gains it was $36.68.

IBM – World Bank swapIBM – World Bank swap

DEM & CHFbondholders

USD Eurobondholders

IBM WB

USD service

DEM & CHF service

USDDEM & CHF

Interest rate swapInterest rate swap

How it works◦Plain vanilla interest rate swap

Other examples of swapsOther examples of swapsSallie Mae and IT&T Financial

Corporation◦Occurred in 1982◦First major domestic interest rate

swap◦“Plain vanilla” swap

Sears & Roebuck◦Hedged against interest rate risk◦Secondary market helped the use of

the swap

Overview of swapsOverview of swapsDifferences between an interest

rate swap and a currency swap◦Notional principal amount◦Players involved

Benefits of the Swap◦Achieve lower cost of financing debt◦Hedging against risks

Secondary marketSecondary marketThree main functions

◦Reverse a position◦Sell a swap to another party◦Buy out counterparty

Swaption◦An option to enter a swap

Enter a normal swap Enter an offsetting swap

Other types of swapsOther types of swapsAmortizing, accrediting, roller-

coaster

Forward start swap

Basis rate swap

Credit default swap

Growth of the swaps Growth of the swaps marketmarket

Possible reasons for growthPossible reasons for growth

Hedge against interest rate risk

Efficiency compared with futures

Arbitrage opportunities

Access to different markets

Intermediaries evolveIntermediaries evolveBanks began strictly as brokers

between two partiesBegan to fill in swap principal

differences◦Example

Bid to Ask spreads narrowed, which meant banks would need to increase the volume of swaps to profit off of swaps

Credit default swapCredit default swapRecent Development

◦Took interest rate and currency swaps ~17 years to reach same notional principal amount as CDSs did in 7 years

Notional Amount Outstanding

-

10,000.00

20,000.00

30,000.00

40,000.00

50,000.00

60,000.00

70,000.00

SummarySummaryIBM & World Bank currency swapWhy companies use the swapSecondary marketDifferent types of swapsRole of financial intermediariesCurrent state of swap market

Questions?