The effect of the new risk-based capital requirements on the market for swaps

The new risk-based capital requirements for banks cover swap agreements as well as the normal on-balancesheet items. The capital calculation is based on a fixed small percentage plus the current market value of the swap, if it is positive. Using option valuation methodology, anticipated capital requirements over the life of a swap are calculated. These requirements are compared to cushions that banks might want to hold against the risks of above average loss rates. For interest rate swaps, the cost of the capital requirements is small, amounting to about 1 bp/year on a swap; in a matched pair, this would amount to 2 bp in the bid-offer spread. On currency swaps, the cost of the capital requirements appears to be much more substantial, closer to 4 bp per year on a swap. In a matched pair, the excess of the capital requirements over desired cushion could amount to 7 bp in the bid offer spread.     

The pricing of interest rate swaps

Interest rate swaps have become an important tool for financial institutions because they provide a convenient way to reduce interest rate risk. Swaps allow financial institutions to obtain short-term deposits in the local deposit market and then transform these into longer-term liabilities. The growth of swaps has been explosive, with the swap market growing from nothing in 1981 to an estimated $889 billion in 1987. In addition to their role in managing interest rate risk, swaps have become important to financial managers for other reasons, and as a result the swap market is monitored by financial managers as are money and capital markets. Because of its growing importance, an empirical perspective on how swaps are priced is needed. This article develops a simple market model and then estimates the model using data provided by three major swap market participants.     

Determinants of Swap Spreads in a Developing Financial Market: Evidence from Finland

This paper presents empirical evidence on the determinants of swap spreads in Finland using four years of data. Spreads exhibit a significant negative relationship with the amount of fixed rate deposits with banks, which reflects the importance of banks in the Finnish capital markets. Spreads are positively linked to business cycle and market risk factors such as the slope of the yield curve and the volatility of interest rates. The influence of hedging costs has become increasingly important over time, especially in longer dated swaps. A relationship is also observed between swap spreads and the external value of the currency.     

Modeling volatility and changes in the swap spread

We investigate the determinants of changes in U.S. interest rate swap spreads using a model that explicitly allows for volatility interactions between swaps of different terms to maturity. Changes in the swap spread are found to be positively related to interest rate volatility, to changes in the default risk premium in the corporate bond market, and to changes in the liquidity premium for government securities. Swap spread changes are negatively related to changes in the level of interest rates and changes in the slope of the term structure. We also find that there is a strong and significant volatility interaction among spreads for swaps of different maturities and that the process for the conditional variance of the spread is highly persistent across all maturities.     

Interest rate swaps

This instructional case is intended to introduce graduate and undergraduate financial accounting and finance students to derivatives using interest rate swaps. The major learning objective is to understand derivative accounting methods, using interest rate swaps, as proposed by the Financial Accounting Standards Board's recent Exposure Draft. A secondary learning objective is to understand key features of a management control system for derivatives' activities. Both matched and unmatched interest rate swap examples are used in this case. The matched swap is based on an actual swap done by a bank for one of its customers. The case is written from the perspective of an audit partner writing a report summarizing interest rate swap accounting and related management controls for a client who wanted to recognize all gains and losses related to its interest rate swaps immediately in current earnings.     

Interest Rate Swaps and Corporate Financing Choices

This paper describes the firm's decision to borrow short-term versus long-term and shows how the introduction of interest rate swaps affects this choice. The model shows that in the absence of a swap market, interest rate uncertainty can lead firms to substitute long-term for short-term financing. However, when swaps exist, there is a tendency for firms that expect their credit quality to improve to borrow short-term and use swaps to hedge interest rate risk. The model suggests that, while the demand for fixed for floating swaps is enhanced, the demand for floating for fixed swaps is reduced by the presence of asymmetric information.     

当前经济形势与互换利率走势判断

2010年上半年,利率互换市场交投活跃。随着市场对经济增长和政策运用预期的不断修正,互换利率继1月创出新高后一路振荡下行。预计下半年,在基本面、政策面、资金面和利率自身波动节奏的相互作用下,市场参与者的预期将反复进行修正,互换利率将呈现宽幅震荡。     

互换利差特征与影响因素——基于人民币利率互换市场的研究

互换利差（Swap spread）是利率互换研究中最重要的问题之一。在国内相关研究仍属空白的情况下,本文首次对人民币利率互换市场的互换利差的变动特征和影响因素进行了统计和计量分析。结果表明,我国互换利差的影响因素较多,包括融资成本、流动性、违约风险因素、利率预期、曲线期限特征因素等。不同基准的利率互换利差影响因素不同,且短期和中长期互换利差影响因素也不相同。另外还发现,不同基准的互换之间、互换与现券之间的定价经常存在扭曲现象,实务中存在较大的套利机会。     

Volatility as an Asset Class: European Evidence

Abstract

Volatility movements are known to be negatively correlated with stock index returns. Hence, investing in volatility appears to be attractive for investors seeking risk diversification. The most common instruments for investing in pure volatility are variance swaps, which now enjoy an active over-the-counter (OTC) market. This paper investigates the risk-return tradeoff of variance swaps on the Deutscher Aktienindex and Euro STOXX 50 index over the time period from 1995 to 2004. We synthetically derive variance swap rates from the smile in option prices. Using quotes from two large investment banks over two months, we validate that the synthetic values are close to OTC market prices. We find that variance swap returns exhibit an option-like profile compared to returns of the underlying index. Given this pattern, it is crucial to account for the non-normality of returns in measuring the performance of variance swap investments. As in the US, the average returns of selling variance swaps are found to be strongly positive and too large to be compatible with standard equilibrium models. The magnitude of the estimated risk premium is related to variance uncertainty and past index returns. This indicates that the variance swap rate does not seem to incorporate all past information relevant for forecasting future realized variance.     

中国利率市场的价格发现——对国债现货、期货以及利率互换市场的研究

本文采用信息份额模型和基于向量自回归(VAR)模型的格兰杰因果检验,研究了国债现货、国债期货和利率互换三个市场之间的价格发现机制。信息份额模型表明,从整体来看利率互换相对于国债期货和国债现货都具有信息优势,而国债期货相对于国债现货具有信息优势。另外,国债期货的价格发现能力相对于另外两个市场都在随时间增强。格兰杰因果检验结果显示,利率互换在价格发现中单向引领国债期货以及国债现货,国债期货单向引领国债现货。所有结果一致表明, 利率互换和国债期货这两种利率衍生产品在引导中国利率市场价格发现中发挥了重要作用。     

Pricing default swaps: Empirical evidence

In this paper we compare market prices of credit default swaps with model prices. We show that a simple reduced form model outperforms directly comparing bonds' credit spreads to default swap premiums. We find that the model yields unbiased premium estimates for default swaps on investment grade issuers, but only if we use swap or repo rates as proxy for default-free interest rates. This indicates that the government curve is no longer seen as the reference default-free curve. We also show that the model is relatively insensitive to the value of the assumed recovery rate.     

The analytic pricing of asymmetric defaultable swaps

Swaps where both parties are exposed to credit risk still lack convincing pricing mechanisms. This article presents a reduced-form model where the event of default is related to structural characteristics of each party. The cash flows submitted to credit risk are identified before the swap is priced. Analytical pricing formulas for interest rate and currency swaps are computed using a Gaussian model for risky bonds. Currency swaps exhibit additional correlation risk. The benefits from netting depend on the balance between exposures and market conditions in valuation. We show that sources of credit risk asymmetries are also likely to impact on credit spreads.     

The Default Risk of Swaps

We characterize the exchange of financial claims from risky swaps. These transfers are among three groups: shareholders, debtholders, and the swap counterparty. From this analysis we derive equilibrium swap rates and relate them to debt market spreads. We then show that equilibrium swaps in perfect markets transfer wealth from shareholders to debtholders. In a simplified case, we obtain closed-form solutions for the value of the default risk in the swap. For interest-rate swaps, we obtain numerical solutions for the equilibrium swap rate, including default risk. We compare these with equilibrium debt market default risk spreads.     

Swaps: Plain and Fanciful

The outstanding face amount of plain vanilla interest rate swaps exceeds two trillion dollars. While pricing and hedging of such swaps appear to be quite simple, many existing theories are based on the incorrect characterization of a swap as a simple exchange of a fixed for a floating rate note. This characterization is not consistent with standarized swap contracts and the treatment of swaps in bankruptcy. This paper provides an alternative perspective on swaps.     

Debt-for-Equity Swaps under a Rational Expectations Equilibrium

This paper analyzes LDC debt-for-equity swaps under a rational expectations equilibrium. Under full information, the swap can never be strictly preferred by the LDC, the MNC, and the bank. Under the postulated informational asymmetry assumptions the same results obtain, leading to the “lemons” market in reverse. Under rational expectations, the swap can only occur if the loan is correctly valued relative to all private information in the economy. Given that some swaps do occur, future models must reflect the unique features of swaps.     

An Economic Analysis of Interest Rate Swaps

Interest rate swaps, a financial innovation in recent years, are based upon the principle of comparative advantage. An interest rate swap is a useful tool for active liability management and for hedging against interest rate risk. The purpose of this paper is to provide a simple economic analysis of interest rate swaps. Alternative uses of and the appropriate valuation procedure for interest rate swaps are described.     

交易商持仓行为对期货市场的影响

金融危机发生之后,CFTC将原有的交易商持仓报告(Commitment of Traders,简称"COT")进行了扩容,新版的COT报告包含现货交易商、互换交易商、管理基金的持仓情况。分析COMEX铜和NYMEX原油的COT报告,可以发现,互换交易商的持仓占比最高,超过30%;具有现货背景的套期保值持仓保持一定比例,大约为20%~50%。现货交易商持仓占比的增加,有助于缓解价格的波动;而互换交易商持仓占比的提高,却加剧了市场的波动。由于互换交易商享有投机持仓豁免的权利,金融危机发生后,CFTC对互换交易商的监管更趋严格。     

Pricing Property Index Linked Swaps with Counterparty Default Risk

This paper extends Bjork and Clapham (Journal of Housing Economics 11:418–432, 2002) model for pricing real estate index total return swaps. Our extension considers counterparty default risk within a first passage contingent claims model. We price total return swaps on property indices with different levels of default risk. We develop this model under same assumptions as Bjork and Clapham (Journal of Housing Economics 11:418–432, 2002) and find that total return swap price is no longer zero. Total return swap payer must charge a spread over the market interest rate that compensates him for the exposure to this additional risk. Based on commercial property indices in the UK, we observe that computed spreads are much lower than a sample of quotes obtained from one of the traders in the market.     

On the Term Structure of Default Premia in the Swap and LIBOR Markets

Existing theories of the term structure of swap rates provide an analysis of the Treasury–swap spread based on either a liquidity convenience yield in the Treasury market, or default risk in the swap market. Although these models do not focus on the relation between corporate yields and swap rates (the LIBOR–swap spread), they imply that the term structure of corporate yields and swap rates should be identical. As documented previously (e.g., in Sun, Sundaresan, and Wang (1993)) this is counterfactual. Here, we propose a model of the default risk imbedded in the swap term structure that is able to explain the LIBOR–swap spread. Whereas corporate bonds carry default risk, we argue that swap contracts are free of default risk. Because swaps are indexed on "refreshed"-credit-quality LIBOR rates, the spread between corporate yields and swap rates should capture the market's expectations of the probability of deterioration in credit quality of a corporate bond issuer. We model this feature and use our model to estimate the likelihood of future deterioration in credit quality from the LIBOR–swap spread. The analysis is important because it shows that the term structure of swap rates does not reflect the borrowing cost of a standard LIBOR credit quality issuer. It also has implications for modeling the dynamics of the swap term structure.     

Characteristics of banks that are more active in the swap market

The impact of swap-related risks on the safety and soundness of the banking system has been a topic of concern. This article provides evidence that some banks may have engaged in swaps as a means to generate income when their loan activities were constrained by the fixed capital requirements. However, the results also suggest that creditworthiness plays an important role. All money center banks (too-big-to-fail) and those nonmoney center banks that are highly rated by S&P experience higher swap demand and achieve higher swap market shares. This implies some market discipline for nonmoney center banks, which may compensate for risk-measurement inadequacies in the current risk-based capital requirements. On the other hand, the results suggest that greater oversight may be required for money center banks.This article was adapted from the dissertation the author completed at the Stern School of Business, New York University. Part of the work was completed while the author was an assistant professor at the School of Management, Syracuse University.Baruch College, City University of New York