Swap and other structured products: Critical review of recent development as tool in financial risk management applications

Term Paper (Advanced seminar) , 2006 , 23 Pages , Grade: A+

Business economics - Banking, Stock Exchanges, Insurance, Accounting

The increased volatility in the financial products world has raised concern about new
possibilities of Risk Management leading into increased use of structured products. Credit
derivatives are financial instruments to manage risk. They isolate such risk from the
underlying financial asset. This essay, firstly, is going to examine
the impact on swap products as a tool in Risk Management followed by an examination of
key areas in structured products development that have experienced the strongest growth in
the last decade. For both types, the current theory and pricing will be outlined
followed by a demonstration of some characteristic applications in Financial Risk
Management.

Introduction

The increased volatility in the financial products world has raised concern about new possibilities of Risk Management leading into increased use of structured products. Credit derivatives are financial instruments to manage risk. They isolate such risk from the underlying financial asset (Gwilym and Meng, 2005). This essay, firstly, is going to examine the impact on swap products as a tool in Risk Management followed by an examination of key areas in structured products development that have experienced the strongest growth in the last decade. For both types, the authors will start outlining the current theory and pricing, followed by a demonstration of some characteristic applications in Financial Risk Management.

Swap Products

A swap describes an agreement among two entities to exchange cash flows in the future. This agreement defines the way in which the cash flows are calculated and the dates when they are exchanged. The calculation usually involves the future value of an exchange rate, an interest rate or another market variable. Since the first swap contracts were agreed in the beginning 1980s - evolving from parallel loan agreements^[1] - the market has seen tremendous growth now being of central importance in the over-the-counter derivatives market (Hull, 2006).

Two umbrella terms of swaps classically exist in the market: Interest rate swaps and currency swaps. During recent years there is a new type of swap product evolving called: Credit Default Swap. The authors are going to discuss all three types of swaps individually well aware of the fact that more (like equity swaps, commodity swaps, volatility swaps etc) as well as combinations of these (like the Cross Currency Interest swap^[2] ) are also possible.

The Interest rate Swap

Interest rate swaps provide a well-situated tool to reduce interest rate risk in several ways. Generally interest rate swaps allow the borrower to enter into short-term borrowing transforming those into a long-term liability (McNulty, 1990).

There are four major theoretical explanations for the existence of interest rate swaps. Titman (1992) developed an asymmetric information model in which one entity believes to have lower future borrowing costs. This entity has incentives to borrow short term (floating) which it then swaps for fixed rate in order to reduce its interest rate expenses.

Wall (1989) develops a theory for the existence of swaps called: agency cost theory by combining underinvestment (Myers, 1977) with the asset substitution problem (Jensen and Meckling, 1976)^[3].

Bicksler and Chen (1986) use the theory of comparative advantage to explain the existence of swaps. Higher rated companies usually can borrow at lower rate than lower rated companies^[4]. This theory is one usually students learn when first getting in contact with swaps as its assumptions allow an easy to understanding of interest rate swap use.

Finally Smith et al. (1986, 1988) developed the theory of expected future downsizing of the amount of debt of a company as a reason for the existence of swaps^[5].

Firms expecting a decline in the most favourable amount of debt can consequently benefit from a swap without abandoning the issue of interest rate risk.

Saunders (1999) tested all these theories and found support for all of them whereas stronger support for the theories of information asymmetry and agency cost. In addition he finds that interest rate swap users “are significantly larger than their industry counterparts and have a significantly higher debt to equity ratio relative to nonusers” (Saunders, 1999, p. 77).

The pricing of interest rate swaps today still follows the treatment of Bicksler and Chen. (1986); they assume that the fixed-rate-player is the seller or buyer of a fixed rate bond and the floating rate player is the buyer or seller of a floating rate bond. The value of the swap can thus be seen as the difference in value of the two theoretical bonds. Most textbooks for students teach this method in valuing a swap; however, this model does not look at the impact of a credit risk premium and neglects the approach of swaps being a basket of futures contracts (McNulty, 1990).

In how far swaps play a role in the fiscal world and are even not to evade for upcoming economies show a recent example of a swap launch in China which the interested reader finds in Appendix 1.

The Currency Swap

IBM and the World Bank were the first to create a currency swap in 1981. Since that time the market for currency swaps as the one for swaps in general has grown enormously at a rate of 20% per year (during the last five years). Global firms usually make use of currency swaps as they offer longer maturities compared to all other foreign exchange derivatives. Goswami et al. (2004) show that non-financial global companies having positive economic exposure preferably borrow long-term home debt which then is swapped against long-term foreign debt as foreign investors exclude the exposure effect when valuing the latter one. Gezy et al (1997) show evidence that currency swap users have significantly higher levels of long-term-foreign-denominated debt than non users of currency derivatives and prefer the use of currency swaps as primary hedging instrument against long-term exposure.

The pricing of currency swap is similar to that of interest rate swaps. Either one takes the difference between two bonds or one values a portfolio of forward foreign exchange contracts (Hull, 2006).

The enthusiastic reader gets an illustration of the development in the Currency Swap market in Asia regarding at Appendix 2.

The Credit Default Swap

A credit default swaps (CDS) guarantees the buyer compensation if one of the following occurs: bankruptcy or debt payment moratorium, repudiation, failure to pay, obligations acceleration or default, and restructuring. The seller of a credit default swap in turn of guaranteeing this compensation charges a fee usually called the CDS premium. The payment in case of default can be in terms of physical settlement – which means the delivery of a physical asset – or in terms of cash settlement (Gwilym and Meng, 2005).

The market for Credit Default Swaps experiences the most marvellous growth of all swap products. It is estimated to double each year with a prediction of accounting for $ 10 trillion by 2007.

The pricing of CDS has gone through several generations of structural models and is not really unified. Structural models, mainly used because of their relatively easy implementation, suffer from three major drawbacks. They require estimates of unobservable firm-parameters, credit rating changes cannot be taken into account and the firm value is assumed to be continuous over time.

Díaz and Skinner (2003) tested several models and found them to overestimate the hazard rate und underestimate the value of the payment to the issuer of a CDS, hence producing positive value for the buyer of such an agreement.

Structural models, therefore, have widely been relaxed, adjusted and replaced by some smaller ones like reduced-form models to bring the modelling closer to reality, however, the work has not been finished and there is no inherently used model available at the moment.

In spite of these current pricing discrepancies the demand for CDS is intrinsically exploding, finding more and more application for investors to use this financial tool. “The building block of such instruments [meant are “derivative instruments”] has been the credit default swap” (Beales and Chung, 2005, pp. 43). The fascinated reader will find an application example of such a CDS in Appendix 3.

General Developments in the Swap Market

Recently the UK inflation swaps gained some life and were traded in higher volumes, this trend might be due to the liability-driven investment by pension funds. Barclays first traded them in 1994, however, the existence of an active asset swap market has surely helped the inflation swap (James, 2006).

Furthermore also the US increased their dollar – limit for a transaction of Pilipino telephone Corp. in 2004. The limit in consideration here was the overbought limit witch caps banks’ dollar exposure to 2.5 % of unimpaired capital or $ 5 million; whichever is lower to protect the local currency against speculative attacks (Dumlao, 2004).

Structured Products: Concepts and Strategy

Structured products are innovative investment vehicles which combine traditional financial products with derivatives, aiming in tailoring risks and returns to an investor specific needs (Malaysia: Hong Leong Bank launches structured products, 2006). In spite of their recent popularity, these instruments were designed in the 1980’s which compels us to class them according to three generations. All generations are built around a common zero coupon bond combined with riskier assets. In the First generation the bond was combined with speculative equity, the second combines a zero coupon bond with traditional financial derivatives and the third with exotic derivatives^[6] (La tribune dossier Gestion d’actif, 2005, p.34).

The creation of a structured product has to be broken down into two steps: Principal protection and yield generation, which will be successively reviewed. In this section, one shall focus on the major type structured products available: structured notes, certificate of deposit and reverse convertible bonds.

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^[1] Parallel loan agreements were popular during the 1970s. For a detailed discussion and their relation to interest and currency swaps, see Abken (1991).

^[2] For an overview of several different types of single and cross-currency interest swaps and swaptations and there numerical valuation, see Dempster and Hutton (1997).

^[3] A firm that wishes to issue long-term debt usually has to pay a premium which is necessary to compensate for underinvestment and asset substitution. These premium payments can be evaded by issuing short-term debt and entering into a swap agreement paying fixed rate. Following this strategy the firm can fix a long-term interest rate evading the extra costs long-term debt usually burdens.

^[4] Following the suggestion of Bicksler and Chen (1986), the higher rated company should borrow long-term and the lower rated company should borrow short-term. Entering into a swap agreement in which the higher rated company pays floating and the lower rated company pays fixed is beneficial to both as they arbitrage the quality spread differential, and hence, have lower borrowing costs.

^[5] A company that has issued long-term debt at a fixed rate and wishes to reduce its debt outstanding might have to repurchase its debt at an amount far above fair market value. Issuing short-term floating debt and entering into a swap contract ensures the fact of a fixed long-term rate but decreases the cost of ‘repurchase’ tremendously as the company can just terminate the swap agreement – which usually is possible by paying the current fair market value of the swap - and stop issuing short-term debt.

^[6] One may wonder why in the recent years the industry has focused on the usage of derivatives as capital appreciation or income generation complementary asset. The answer lies in the fact that employing equity derivatives provides leverage and allows investment professionals to create a variety of risk and return profiles. Therefore by using a derivative with intrinsic risky or non-risky properties linked to an underlying speculative or non-speculative asset, one can tailor an instrument that fits the investor’s market view, and risk tolerance (Ross, 2005).

• College: University of Westminster
• Course: Financial Derivatives
• Grade: A+
• Authors: Frédérik Arns (Author), Franklin Schram (Author)
• Publication Year: 2006
• Pages: 23
• Catalog Number: V57496
• ISBN (eBook): 9783638519489
• ISBN (Book): 9783638665384
• Language: English
• Tags: Swap, Critical, Financial, Derivatives