What is a swap?
A bilateral OTC derivatives contract in which 2 parties agree to exchange cash flows on a notional amount over a period of time. This is done based on an agreed-upon payment schedule through the life of the contract.
What is the simplest swap?
Plain vanilla interest rate swap.
What is a plain vanilla interest rate swap?
Fixed-rate for floating-rate risk. A swap in which one party exchanges fixed rate payments for floating rate payments based on an underlying index such as LIBOR. This converts the party's floating rate loan to a fixed rate loan.
Is principal exchanged in a plain vanilla interest rate swap?
No. The notional value is merely a reference amount used to calculate each party's obligations under the swap agreement.
Can a plain vanilla swap be used for other asset classes?
Yes. A plain vanilla swap can be used when the underlying is stocks (equity swap), or oil (energy swap). It can be used with several other financial transactions.
What are the risks in a plain vanilla swap?
If the underlying rates for the interest are on different indexes, there is some basis risk.
What are the types of currency swaps?
Foreign exchange swap and foreign currency swap.
What is a foreign exchange swap?
A simultaneous purchase and sale of an amount of foreign currency for two different value dates.
What is a foreign currency swap?
When two counterparties exchange streams of interest payments in different currencies for an agreed period of time and to exchange principal amounts in different currencies at a pre-agreed exchange rate at maturity.
What is a difference check?
A payment for the net obligation instead of exchanging periodic interest payments. Sometimes used as an alternative for the initial excahnge of principal.
What is the difference between a foreign exchange and foreign currency swap?
Foreign currency swaps can use significant financial leverage, since there is no exchange of underlying principal. This is different than foreign exchange swaps which do shift principal between two currencies during the contract.
What are credit derivatives?
Off-balance sheet financial instruments that permit one party (beneficiary) to transfer the credit risk of a reference asset (which it owns) to another party (guarantor) without actually selling the asset. This transfers credit risk from a protection buyer to a credit protection seller.
What is a credit default swap?
A bilateral financial contract in which a protection buyer makes periodic payments to a protection seller in return for a contingent payment if a predefined credit event occurs in the reference credit.
What are some of the risks hedged by CDS?
Political risk, credit risk, counterparty risk, and legal risk.
How are CDS documented?
1) Standard ISDA Master Agreement, 2) Negotiated schedules, which outline deviations from the ISDA agreement and 3) confirmations, which define the precise risk parties want to transfer.
Eternity Global v. Morgan Trust
Dispute over whether a credit event with the Argentinian govt occurred. Four step method to assess ambiguity: 1) Look at express terms and language in the agreement, 2) ISDA Master Swap Agreement, 3) Version of ISDA definitions incorporated into disputed contracts, 4) Extrinsic evidence.
Aon Financial v. Societe Generale
Dispute over whether the reference entity was the Government Service Insurance System (GSIS) or the Republic of the Philippines. Court held that Societe Generale was not liable for the CDS with AON. First amicus brief by the ISDA. Look at language, if ambiguous, give effect to the contract as written.
What are the two models for the trading of derivatives?
The central clearing model and the OTC model.
MF Global Bankruptcy
Questioned the new central clearing regime put in place by Dodd-Frank. MF Global was an approved futures commission merchant (FCM). Due to the lack of segregation for customer funds as well as repo agreements for foreign soverign debt, they filed for bankruptcy in 2011.