Finance and Financial Markets

Third Edition

by Keith Pilbeam

Chapter 16 - Swap Markets

Find an overview and useful learning resources below to accompany Finance and Financial Markets chapter sixteen.

Chapter Introduction

A swap is an agreement between two parties to exchange two differing forms of payment obligations. There are basically two types of swap: an interest rate swap and a currency swap. In an interest rate swap the exchange involves payments denominated in the same currency, while in a currency swap the exchange involves two different currencies.

The first well documented swap was a currency swap between the World Bank and International Business Machines (IBM) in 1981, whereby the World Bank committed itself to financing some of IBM’s deutschmark/Swiss franc debt in return for a commitment by IBM to finance some of the World Bank’s dollar debt. Since the early 1980s there has been an enormous growth in the swap market, and Table 16.1shows the value of interest rate swaps and currency swaps for the period 1998–2008.

Like many other financial instruments, swap agreements are used to manage risk exposure; however, as we shall see, one of the main reasons for the rapid growth of the swap market has been that they enable parties to raise funds more cheaply than would otherwise be the case. The swap market is used extensively by major corporations, international financial institutions and governments, and is an important part of the international bond market. Th e swap market is currently organized by the International Swaps and Derivatives Association (ISDA) which, since 1985, has been responsible for standardizing documentation and dealing terms.

In this chapter we look at both interest rate and currency swaps, and in particular we focus on the economic advantages of swaps and the reasons for the existence of swap opportunities. We also focus attention on the role played by intermediaries in arranging swaps, and finally look at some of the innovations that have occurred in the swap market.

Learning Objectives

In this chapter you will learn about:
  • ​The potential situations that may lead to a mutually beneficial swap
  • How swaps can arise from both absolute and comparative advantages in the capital markets
  • The difference between an interest rate swap and a currency swap
  • The crucial role played by intermediaries in the swap market
  • How to interpret swap rates published in the financial press
  • Innovations in the swap market

Further Reading

Das, S. (2006) Swaps/Financial Derivatives: Products, Pricing, Applications and Risk Management, 3rd edn, Wiley.

Flavell, R. (2002) Swaps and Other Derivatives, 2nd edn, Wiley.

Kolb, R.W. and Overdahl, J. (2007) Futures, Options and Swaps, 5th edn, Basil Blackwell.

Sadr, A. (2009) Interest Rate Swaps and their Derivatives: A Practitioner’s Guide, Wiley.

Revision Questions

  1. Explain the difference between an absolute advantage swap and a comparative advantage swap.
  2. Explain the difference between an interest rate swap and a currency swap.
  3. Explain with the aid of a numerical example why in a plain vanilla swap the total potential gain from a swap is limited to a certain amount.
  4. Explain what is meant by a swap reversal and discuss an alternative way of ending a swap obligation.
  5. Explain how a swap may prove a useful way for a firm to hedge interest-rate risk when the firm has a lot of floating-rate debt on its books.

Multiple Choice Questions

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