Swap in Risk Reduction Derivative Markets Have

¶ … Swap in Risk Reduction Derivative markets have evolved for the last few years and they currently offer contracts on any financial security. They offer contracts to hedge any investment risk. Swap is one such derivative that is used to hedge investment risk. Its use has gained popularity because it is one of the most efficient ways to hedge common and specific financial risks which characterize many portfolios (National Association of Pension Funds, 2005).

The term swap encompasses an extremely wide-ranging variety of instruments namely: interest rate swaps, inflation rate swaps, and portfolio swaps. Perhaps before we delve deep into the different types of swaps it is imperative that we ventilate what swaps really are. Swaps are contractual agreements between two parties to exchange future cash-flows on pre-determined dates over a specified period. Interest rate swaps is the most basic swap contract where party to the contract pays a fixed rate of interest while the other party pays a floating rate of interest.

Swaps are tailored to the needs of the party paying floating rate of interest and the other paying fixed rate of interest (Whittaker, 1987). Swaps are therefore not traded on an exchange but over the counter (OTC). Brokers normally provide live tradable price quotes for a wide range of swaps. Brokers, by acting as intermediaries between investors, provide liquidity to the market.

Swaps are flexible instruments because various details of swap can be amended on mutual agreement between the party paying the floating interest rate and the other paying fixed interest rate. Swaps can be used by companies, pension schemes and insurance schemes, and central banks. Companies can use swaps to reduce risks and manage their debts more efficiently for example by exchanging a floating interest rate exposure for a fixed interest rate exposure (Whittaker, 1987). Pension schemes and insurance schemes basically use swaps to manage interest rate risks.

Finally, central banks use swaps to control their balance sheets and exploit market opportunities. In our previous discussion we discussed the flexibility of the interest rate swaps and the fact that there has to be two parties, one paying floating rate of interest and the other paying fixed rate of interest. Inflation rate swaps are different from interest rate swaps in that counterparty B.

pays a fixed rate in exchange for the prevailing rate of inflation thus protecting a company in contract with them against effects of inflation on the bond portfolio (National Association of Pension Funds, 2005). Pension Funds benefit from entering into inflation rate swaps by obtaining inflation-linked assets matching its inflation-linked liabilities. As opposed to interest rate swap markets, inflation rate swap markets are not liquid. They nevertheless, are capable of meeting companies fund needs efficiently.

Portfolio swaps involve simple exchange of cash flows where a company buys bonds and agrees to pay the coupons and the principal repayments from those bonds to an investment bank as they fall. The investment bank in exchange pays the company a pre-defined series of cash flows tailor-made to the requirements of the company. The company therefore achieves improved cash-flow matching.