Describe how financial intermediaries function in the market for swaps.
The idea
Most end users of swaps do not find a natural counterparty with the opposite needs. A financial intermediary, usually a bank acting as swap dealer, stands in the middle. It quotes a bid and an offer fixed rate against the floating rate. It pays the lower rate and receives the higher, and the gap, often a few basis points, is its compensation. In a matched book the dealer enters two offsetting swaps and takes the spread. But it has two separate contracts, so if one party defaults it must still honour the other swap and may be left with market risk. A dealer without an offsetting counterparty warehouses the swap and hedges it with bonds, futures or other swaps until a match appears. The common error is to treat the dealer as risk free because the book is matched.
A practice question
What is the main role of a financial intermediary in the swap market?
- Setting the floating reference rate on which payments are based.Why not: The reference rate comes from the market or its administrator, not from the swap dealer.
- Matching buyers and sellers for a commission without taking the other side.Why not: Dealers act as principal and take the other side; they do not act as agents.
- Acting as counterparty to end users and earning a bid-offer spread on offsetting swaps. - correct
- Guaranteeing both sides' payments so that neither party faces credit risk.Why not: Intermediaries do not guarantee payments; each swap is a separate contract with its own credit risk.
Swap dealers stand between end users, entering offsetting swaps and earning the spread between the rate they pay and the rate they receive. They carry credit and market risk, not remove it.
A harder one
A swap dealer has a matched book. It receives 4.01% fixed from Company X and pays 3.97% fixed to Company Y, with identical notional USD 100 million and identical floating legs. What is the dealer's net annual spread income?
- USD 0.08 millionWhy not: Counts the 4 basis point spread on both swaps, double counting it.
- USD 0.02 millionWhy not: Takes one semi-annual period's spread income instead of the annual amount.
- USD 0.40 millionWhy not: Treats 0.04% as 0.4%, an error of a factor of ten.
- USD 0.04 million - correct
The floating legs cancel; the net fixed is 4.01% - 3.97% = 0.04%. On USD 100 million that is USD 0.04 million per year.
The hardest tier
A dealer receives 4.2% fixed on USD 80 million from Client X, and pays 3.8% floating to Client X. With Client Y it pays 4.15% fixed and receives 3.8% floating, on USD 60 million. Payments are semi-annual and the floating rate for the period is 3.8%. What is the dealer's net cash flow for the period across both swaps?
- Receives USD 0.055 million - correct
- Receives USD 0.015 millionWhy not: Applies the spread to USD 60 million only and ignores the unmatched floating payment on the extra USD 20 million.
- Receives USD 0.815 millionWhy not: Adds the floating payments to the fixed ones instead of netting them.
- Receives USD 0.020 millionWhy not: Applies the 5 basis point spread to the full USD 80 million, ignoring that the notionals differ.
Fixed: 1.680 received - 1.245 paid = 0.435. Floating: 1.140 received - 1.520 paid = -0.380. Net = 0.055. The mismatched notional leaves the dealer paying floating on USD 20 million, so it is exposed to rising floating rates.
In the app: 6 practice questions on this outcome, spaced review that brings it back before you forget it.
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- Work out the cash flows of a plain vanilla interest rate swap, explaining how it operates.
- Show how a plain vanilla interest rate swap converts an asset or liability into a different one, and work out the cash flows that result.
- State what function confirmation serves in a swap transaction.
- Set out the comparative advantage argument behind interest rate swaps and evaluate some objections to it.
- Describe how a plain vanilla interest rate swap's discount rates are computed.
- Value a plain vanilla interest rate swap as two bond positions held simultaneously.
- Treat a plain vanilla interest rate swap as a strip of FRAs and use that to value it.
- Show how a currency swap converts an asset or a liability into another and compute the cash flows that follow.
- Value a currency swap as two bond positions held simultaneously.
- Use a series of forward exchange rates to value a currency swap.
- Recognise exotic swaps, credit default swaps, volatility swaps and commodity swaps as further types of swap and describe them.
- Outline how credit risk exposure arises for a party holding a swap position.