What are Swaps? Financial Derivatives Tutorial - YouTube

Hello my name is Patrick Boyle, welcome back to my YouTube channel where we're

learning all about finance and derivatives. In today's video we're going

to learn all about swaps. OK so today we'll learn all about swaps what are

they? how do they work? who trades them? and how do they pay out? Instead of going

straight to a definition, let's just firstly discuss the idea of the swap. For

some reason, a lot of students really hate learning about swaps, as they think

that they're complicated and confusing, but in truth they're neither of these

things. A lot of the material that we've already covered about options, is a lot

more difficult than swaps. There is no complicated formula for valuing swaps or

anything like that, the way there is for options, so don't worry too much about

them and let's think about what they are. So when I teach this class at King's

College or Queen Mary University, I often start out with a story. I say, well let's

imagine that you're a university student and in the final year of your degree and

after the exams you go out with a drink with your best friend from college.

So the two you go out and you say, well we're just gonna have one drink righ?t

We'll have one quick drink, and then we'll go home you know, but the

night goes on you know, you have two or three drinks you have a few more and

things are getting a bit sloppy. You turn to your friend and you

say, you know you're the smartest person in the class, and your friend says no no

no you are by far the smartest person. you're, everyone thinks, everyone says

that you are the best student in this degree program. You will be the most

successful student. And you say to your friend, oh no no, you will be the most

successful student. I know this better than I know anything. And so the argument

goes on and o,n and you know you decide to have maybe another drink while you

discuss it. By the end of the night you've come to an agreement with your

friend. You've said to them you know what I have so much faith in you and how

smart you are and how well you're gonna do in life now what I'd like to do is

enter into an agreement with you what we'll do is we'll both go out and we'll

get the best jobs that we can get and well happen is that I at the end of each

month will sign over my paycheck to you you will sign over your paycheck to me

and because I have so much faith in you I think I'll do better with that

transaction and I will with just cashing my own paycheck and your friend agrees

and off you guys go so then as time passes what happens well you get you get

a really good job you know things work out for you you've got a really top job

but one of the top investment firms and you know you're you're making an awful

lot of money but of course the problem is that you're not really making a lot

of money because you're you're handing over your paychecks to this friend of

yours and your friend of course your friend actually was right there a lot of

faith in you and they knew you'd get a great job and so they just went they got

a job at a local restaurant you know they're flipping burgers at the

restaurant but they are receiving all of your big investment banking paychecks

you know so you are at this point will say a couple of years into it you're the

head of M&A at the biggest best investment bank and your friend is you

know there's there's still you know flipping hamburgers so what happens well

obviously you've lost out on that trade but really all that was all that

agreement that you entered into was just a swap, where we took two cash flows that

we didn't know what they would be and we agreed at time zero that they were

probably equivalent and we exchanged them and then of course after the event

we start to see what the two cash flows will be and we see who wins and who

loses in that transaction well let's think a little bit more about it so how

do we price that once once the swap is running you know once things are

happening we get to see the paychecks and we'll assume that people's paychecks

are just going to grow at the rate of inflation for example which is probably

a reasonable assumption maybe not early in your career but for a lot of people

it is and so all we need to do to price this transaction is we just need to

present value these two cash flows and the difference between the present value

of these two cash flows will be the amount you'd have to pay to get out of

that transaction now I guess I left out of that transaction maybe you had made

this agreement with your friend to do for five years you know so if we're

three years into it in order to value it you just have to look at the expected

cash flows of your income over the next two years and their expected cash flows

and the difference between these is how much this swap transaction is worth okay

so now you know what a swap is and how it works but let's see if we can come up

with a slightly more formal definition for one so a swap is a financial

derivative in which two counterparties exchange the cash flow of one party's

financial instrument for those of the other parties financial instrument for a

period of time stated in the agreement these cash flow streams are referred to

as the legs of the swap the swap agreement defines the dates when the

cash flows are to be paid and how they're calculated the cash flows are

calculated over a notional principal amount the notional amount is usually

not exchanged between counterparties it's just used as a reference from which

the size of the two payment streams can be calculated usually at the swaps

inception at least one of the cash flows is an uncertain variable such as a

floating interest rate the change in value for the uncertain cash flow will

benefit one of the two parties financially however both parties may

benefit overall if not financially by reducing financial uncertainty as

explained in my earlier video which was called should companies use derivatives

to hedge a link to that above the very first swap was negotiated in 1981 when

IBM and World Bank entered into a swap agreement since then swaps have become

one of the most heavily traded types of derivatives in the world interest rate

swaps can be most easily understood as an exchange of loans consider two

parties that have taken out loans of equal value the first is borrowed at a

fixed rate and the other at a floating rate both would like to balance their

portfolio to limit risk the two then agree to exchange their loans are swap

interest they might be doing this as a hedge to

reduce their overall interest rate risk or to speculate on the future direction

of interest rates the principal amount of the two loans is the same thus

there's no need to exchange principal leaving only the quarterly cash flows to

be exchanged the party that switches to paying a floating rate might request a

premium or offer a discount on the original fixed borrowers rate depending

on how interest rate expectations have changed since the inception of the

original loans the original fixed rate plus the premium are - the discount

would be the equivalent of a swap rate so what is the commercial need for swaps

the normal commercial operations of many businesses lead to risks associated with

interest rates or foreign exchange will take for example a US Savings and Loan

bank savings and loans accept deposits and pay a floating rate of interest on

them they then lend those deposits out as home mortgages in the United States

home mortgages are typically fixed interest rate loans as opposed to the

floating rate loans in the United Kingdom as a result a US-based savings

and loan bank can be left with fixed-rate assets and floating rate

liabilities this would lead to losses in a rising interest rate environment to

escape this interest rate risk the Savings & Loan Bank could use the swaps

market to convert either their liabilities to fixed rate or their

assets to floating rate initially interest rate swaps helped corporations

manage their interest rate risk exposures however because swaps reflect

the markets expectation for interest rates in the future

swaps also became an attractive tool for other fixed income market participants

including investors speculators and banks so what is a plain vanilla swap

the term plain vanilla when used in finance usually signifies the most basic

or standard version of a financial instrument plain vanilla is the opposite

of an exotic in ermand which is a term used to describe

a more complex security the most common type of swap is known as a plain vanilla

interest rate swap which involves one counterparty paying a fixed rate to

another counterparty while receiving a floating rate index to a reference rate

like LIBOR and return by market convention the counterparty paying the

fixed rate is the hair and the counterparty receiving the fixed rate is

the receiver see the diagram on screen right now which shows the two

counterparties and the cash flows of the swap the notional principal is an amount

used as a basis for calculations it is not actually transferred between the two

counterparties if for example the notional principal is 1 million dollars

this then allows us to calculate the amount of the payments based on the two

interest rates for each exchange the floating rate is said at the beginning

of the period and paid at the end of the period in order for swap to be valued at

zero at inception the present value of the two legs of the swap must be equal

if you calculate the net present value of the two cash flows the correct fixed

rate is the one at which the two cash flows have an equal present value okay

so let's look at an example suppose two companies ABC and XYZ agree to an

interest rate swap ABC agrees to pay a fixed rate at four percent an XYZ agrees

to pay a floating rate at LIBOR the notional principal is a hundred million

dollars payments are semiannual and the maturity is three years you can see that

swap diagram on the screen right now at the outset we don't know who will win

since we don't know the part that Libor rates will actually take in the future

we do know that there are six cash flow exchanges and that at each point ABC

will pay XYZ two million dollars assume now that the three years has passed the

table showing on screen right now shows how to swap worked out

note that the notional principal in this example $100,000,000 does not change

hands at any point between the two parties it would make no sense for them

to wire each other an identical amount of money at the outset it's just a

figure upon which the individual interest rate calculations are based

note that the interest rate swap allows the counterparties to do the same thing

as the savings and loan bank mentioned earlier that is to change borrowings

from fixed to floating or vice versa in the example ABC switched its borrowing

from floating to fixed believing interest rates would rise and XYZ

switched its borrowing from fixed to floating believing that rates would fall

so let's now learn a bit about the interest rate swaps market a significant

industry has grown in order to facilitate swap transactions initially

investment banks would match counterparties and charge them a fee

over time they moved to a model where they make markets in interest rate swaps

and would charge a spread the spread charged compensates the dealer for the

risk of counterparty default the risk of mismatched entry timing to each leg and

provides a profit dealers often have a portfolio of swaps to manage and can

find themselves exposed to the very risks their customers are trying to

avoid there are many market participants who

transact in swaps swap brokers service information

intermediaries they have a number of potential counterparties in their

contact list and stand ready to find a suitable counterparty first swap upon

demand the broker will protect the identity of the interested parties until

they have found a very likely counterparty for their services a swap

broker receives a fee from each of the counterparties swap dealers serve as

financial intermediaries and fulfill all of the roles of the swap broker but they

may also take risk positions in swap transactions by becoming an actual party

to the transaction usually the swap dealer will take a risk position in

order facilitate the trade of the initial

customer but then they'll quickly see per offset that risk in the market the

swap dealer will charge a spread as shown on the screen right now most swaps

are traded over the counter but some types of swaps are also traded on

exchanges such as the Chicago Mercantile Exchange the CBOE the Intercontinental

exchange and your eggs so who trade swaps then let's look at five different

groups number one company treasurer's companies can set up swaps to hedge

their interest rate exposure or to more closely match their assets or income

stream as explained above number two speculators swaps give fixed income

traders away to speculate on movements in interest rates while reducing the

cost of long and short positions in Treasuries instead of buying a Treasury

bond to speculate on a fall in interest rates a trader could receive fixed in a

swap which gives a similar payoff should interest rates fall but does not require

the investor to put up as much capital number three portfolio managers interest

rate swaps give fixed income portfolio managers the ability to quickly add or

reduce the duration of their portfolio they give portfolio managers a way of

adjusting interest rate exposure and offsetting the risks posed by interest

rate volatility long-dated interest rate swaps can be an effective tool in

liability driven investing allowing portfolio managers to increase the

duration of a portfolio where the aim is to match the duration of assets with

that of long term liabilities number four risk managers financial

institutions are usually involved in a huge number of transactions involving

loans derivatives contracts and other investments all of which can expose the

institution to interest rate risk this risk can be managed using swaps number

five bond issuers when corporations decide to issue bonds they usually lock

in an interest rate by entering into swap contract

that gives them time to go out and find investors for the bonds once the bonds

are sold they can exit the swap contracts the swap contracts will have

hedged the interest rate risk between the sales pitch for the bonds and the

actual sale the importance of swaps and markets currency swaps originated when

foreign exchange traders entered these agreements to work around British

controls on the movement of foreign currency the first interest rate swap

was negotiated in 1981 between the World Bank and IBM IBM at the time had large

amounts of Swiss franc and German Deutsche Mark debt, IBM and the World

Bank worked out an agreement in which the World Bank borrowed dollars in the

US market and swapped the dollar payment obligation to IBM in exchange for taking

over IBM Swiss franc and deutsche mark obligations the swap market has grown

immensely since then the notional dollar value of outstanding interest rate swaps

globally was 318 trillion dollars at the end of 2017 according to the Bank for

International Settlements. The swaps market gave rise to ISDA, the

International Swaps and Derivatives Association - the global trade association

that created the core documentation for the over-the-counter derivatives world.

I'll probably do a video on the is de Master Agreement sometime soon

swaps today are easily the largest part of the derivatives world by notional

value is outstanding so that's it you made it all the way to the end so do hit

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button comment below if there are any additional topics you'd like to see me

cover in these videos tune in tomorrow to learn about currency swaps see you

then and have a great day bye

you