Swaps Obligate Each Party to the Contract to Exchange (Swap) a Set of Payments for Another Set of Payments

In addition to forwards, futures, and options, financial institutions use one other important financial derivative to manage risk. Swaps are financial contracts that obligate each party to the contract to exchange (swap) a set of payments (not assets) it owns for another set of payments that are owned by another party. Swaps are of two basic kinds. Currency swaps involve the exchange of a set of payments in one currency for a set of payments in another currency. Interest-rate swaps involve the exchange of one set of interest payments for another set of interest payments, all denominated in the same currency. We focus on interest-rate swaps.

Interest-rate swaps are an important tool for managing interest-rate risk. They first appeared in the United States in 1982, when, as we have seen, demand increased for financial instruments that could be used to reduce interest-rate risk. The most common type of interest-rate swap (called the plain vanilla swap) specifies: (1) the interest rate on the payments that are being exchanged; (2) the type of interest payments (variable or fixed-rate); (3) the amount of notional principal, which is the amount on which the interest is being paid; and (4) the time period over which the exchanges will continue to be made. There are many other, more complicated versions of swaps, including forward swaps and swap options (called swaptions), but here we will look only at the plain vanilla swap. Figure 13-4 illustrates an interest-rate swap between First Trust and the Friendly Finance Company. First Trust agrees to pay Friendly Finance a fixed rate of 7% on $1 million of notional principal for the next 10 years, and Friendly Finance agrees to pay First Trust the one-year Treasury bill rate plus 1% on $1 million of notional principal for the same period. Thus, as shown in Figure 13-4, every year First Trust would be paying the Friendly Finance Company 7% on $1 million while Friendly Finance would be paying First Trust the one-year T-bill rate plus 1% on $1 million.

—Frederic S. Mishkin and Apostolos Serletis, The Economics of Money, Banking, and Financial Markets, 6th Canadian ed. (Toronto: Pearson Canada, 2016), 332.

Margin Requirements and “Marking to Market” Protect a Futures Exchange by Making Trader Default Much Less Likely

To make sure that the clearinghouse is financially sound and does not run into financial difficulties that might jeopardize its contracts, buyers or sellers of futures contracts must put an initial deposit, called a margin requirement, of perhaps $2000 per Canada bond contract into a margin account kept at their brokerage firm. Futures contracts are then marked to market every day. At the end of every trading day, the change in the value of the futures contract is added to or subtracted from the margin account. Suppose that after buying the Canada bond contract at a price of 115 on Wednesday morning, its closing price at the end of the day, the settlement price, falls to 114. You now have a loss of 1 point, or $1000, on the contract, and the seller who sold you the contract has a gain of 1 point, or $1000. The $1000 gain is added to the seller’s margin account, making a total of $3000 in that account, and the $1000 loss is subtracted from your account, so you now only have $1000 in your account. If the amount in this margin account falls below the maintenance margin requirement (which can be the same as the initial requirement, but is usually a little less), the trader is required to add money to the account. For example, if the maintenance margin requirement is also $2000, you would have to add $1000 to your account to bring it up to $2000. Margin requirements and marking to market make it far less likely that a trader will default on a contract, thus protecting the futures exchange from losses.

—Frederic S. Mishkin and Apostolos Serletis, The Economics of Money, Banking, and Financial Markets, 6th Canadian ed. (Toronto: Pearson Canada, 2016), 320.

Hedging Risk Involves Offsetting a Long Position by Taking an Additional Short Position or Vice Versa

Financial derivatives are effective in reducing risk because they enable financial institutions to hedge, that is, engage in a financial transaction that reduces or eliminates risk. When a financial institution has bought an asset, it is said to have taken a long position, and this exposes the institution to risk if the returns on the asset are uncertain. Conversely, if it has sold an asset that it has agreed to deliver to another party at a future date, it is said to have taken a short position, and this can also expose the institution to risk. Financial derivatives can be used to reduce risk by invoking the following basic principle of hedging: hedging risk involves engaging in a financial transaction that offsets a long position by taking an additional short position, or offsets a short position by taking an additional long position. In other words, if a financial institution has bought a security and has therefore taken a long position, it conducts a hedge by contracting to sell that security (take a short position) at some future date. Alternatively, if it has taken a short position by selling a security that it needs to deliver at a future date, then it conducts a hedge by contracting to buy that security (take a long position) at a future date.

—Frederic S. Mishkin and Apostolos Serletis, The Economics of Money, Banking, and Financial Markets, 6th Canadian ed. (Toronto: Pearson Canada, 2016), 312-313.