What Are Swaps?

If you're not awake, swaps have the potential to be a little bit confusing, so pay attention!


Generally speaking, a swap is a form of derivative that's used to help large institutions hedge risk, or reduce costs by the exchanging of cash flows in relation to certain underlying asset groups.


In this example, I'm going to write specifically about interest rate swaps, but swaps can be used for foreign exchange hedging or even speculating on the movements of prices.


How it works:

For this example we have two companies that both want to borrow £1,000,000 and a Swaps Bank:


Company 1 - Wants to borrow at a variable interest rate.

Company 2 - Wants to borrow at a fixed interest rate.


Company 1 goes to its bank, which we'll call Bank 1.

Company 2 goes to its bank, which we'll call Bank 2.


Bank 1 tells Company 1 that if it wants to borrow at a fixed rate it will have to pay 9% and if it wants to borrow at a variable rate it will have to pay the LIBOR (London Inter Bank Offer Rate).

Bank 2 tells Company 2 that if it wants to borrow at a fixed rate it will have to pay 12% and that if it wants to borrow at a variable rate it will have to pay LIBOR +1% (i.e. if LIBOR is 5% they would pay 6%, etc).


Now, the two companies could just accept the rates they're offered, but in the event that they don't want to, a swaps bank can act as an intermediary body, make some money for itself and give the banks the loans they initially wanted:


Despite wanting to pay a variable rate, let's assume that the Swaps Bank tells Company 1 to take the fixed rate of 9% on their £1,000,000 loan.

Despite wanting to pay a fixed rate, let's assume that the Swaps Bank tells Company 2 to take the variable rate of LIBOR +1% on their £1,000,000 loan.


                                       Fixed 9%                                                
                    ------------------------------------->                
   Company 1                                                 Bank 1
                    <------------------------------------                  
                                       £1,000,000                    


                                       LIBOR +1%                                                 
                    ------------------------------------->                
   Company 2                                                 Bank 2
                    <------------------------------------                  
                                       £1,000,000                  


Halfway Point Summary:


We're about halfway through the transaction and so far both companies have taken their £1,000,000 loans from their respective banks, but at the rates that they didn't want to have.

Here's where the Swaps Banks comes into play, giving them the rates they want and reducing the costs of said rates:



Continuing:


So, the Swaps Bank does a separate deal with each client (it effectively swaps over their interest rates):


The Swaps Bank tells Company 1 that they'll agree a swap on the notional amount of £1,000,000 (it's already got the £1,000,000 in cash from Bank 1), so they'll swap the fixed interest rate to a variable interest rate, but nothing else.

So the Swaps Bank pays Company 1 a fixed rate of 10% on a notional rate of £1,000,000 and receives LIBOR on said £1,000,000.


The Swaps Bank tells company 2 that they'll agree a swap on the notional amount of £1,000,000 (it's already got the £1,000,000 in cash from Bank 2), so they'll swap the variable interest rate to a fixed interest rate, but nothing else.

So the Swaps Bank pays Company 2 LIBOR on a notional rate of £1,000,000 and receives an 10.5% fixed rate on said £1,000,000.


What will happen is that every six months or so, the Swaps Bank will settle the difference for the companies between the rate they're paying the bank and the rate the bank is paying them on £1,000,000.



                                       LIBOR                                                            LIBOR
                    ------------------------------------->                  -------------------------------------->
   Company 1                                                 Swaps Bank                                                    Company 2
                    <------------------------------------                   <--------------------------------------
                                        10%                        0.5% Profit                      10.5%



How The Swaps Bank Makes Money:


The Swaps Bank makes money through taking in more from Company 2 than it's paying out to Company 1:

The Swaps Bank gets 10.5% from Company 2 and Pays 10% to Company 1, thus netting a 0.5% profit.

This may not seem like very much, but in the context of much larger sums of money over many years, these can become highly profitable transactions for the Swaps Bank.



Company Benefits:


In the case of Company 1, they could have paid LIBOR at the bank for a variable rate loan, but with this swap in place they're effectively paying LIBOR -1%, because LIBOR was paid to the Swaps Bank, but they're receiving 10% on £1,000,000 while only paying out 9% to the bank (9%-10%=-1%).


In the case of Company 2, they could have paid 12% at the bank for a variable rate loan, but with this swap in place they're effectively paying 11.5%. This is because LIBOR effectively cancels out between the Swaps Bank and Bank 2 (10.5%+1%=11.5%), making a saving of 0.5% and giving them the fixed rate they wanted.


Risks:


As with pretty much everything in finance there are risks, with the number one risk in this case being that one of the companies will go bust and thus land our Swaps Bank with an unbalanced and unprofitable deal. To hedge against this, most swaps banks will take some form of collateral from the two companies and also carry out a lot of due diligence regarding cash flows, etc.



I hope this clears up any issues with understanding interest rate swaps.

All the best,

The Masked AIM Trader

The Global Economy

Good evening,

I think that before embarking on a quest to make a position in the stock market in any capacity, be that long or short, one needs to have an opinion on the global stock markets and the worldwide economic situation. 

I've had two opinions on the global economic climate since I started actively managing my portfolio: 

The first opinion that I held adamantly for several months was that the global markets were destined to capitulate and sink again as they did in 2008/9.

The second opinion (one that I still hold) is that the global economies aren't necessarily in a great position overall, but that the the stock markets will continue to rise as a result of external pressures. 

My reasoning behind moving from the first opinion was that I very quickly realised that it's become very popular to take the counterargument when it comes to discussing the stock markets. Now, what I'm about to say doesn't really apply to AIM (where I primarily invest), but it does hold true across world markets:

The market is like a super-computer that processes all of the information in the market and then comes up with an appropriate price as close to the "true value" of the market as possible.

Therefore, if the stock market has been rising for a week, it's not necessarily true to say that the value within that market has increased, but that the price has. 

This is important in my opinion, because it's the main driving point behind my current market opinion (since January 2014). I am a believer that the global stock markets will continue to rise because the external interest rate factors have made the stock market the only place where a return above inflation can be made. In short: value has not necessarily increased with this bull run of the stock market, but prices have.

As a traders we primarily profit from being able to determine the effects on the price of an instrument and not the value (although value investors do certainly exist and I have a lot of respect for them). It's because of this that I'm comfortable with still going long on the S&P 500 and the FTSE 100, but nevertheless, I believe that we have to be very careful as investors and traders not to become pulled in too much by the current bull run.

For example, jobs and housing figures in the US has only recently began to deliver more consistently positive results and yet the markets have continued to rise.


To conclude, it's in my eyes that the current bull run is sustainable and that we could likely see further increases in the major stock indices. I am therefore bullish on price increases, but not necessarily bullish on the value added to our major markets. Low interest rates that seem likely to remain low as a result of uncertain macro-economic conditions worldwide. This combined with the environment created by quantitative easing makes the bullish pattern seem stronger in my eyes.


Good luck and good night.