forward markets, futures markets are highly regulated at the national level. National regulators are required to approve new futures exchanges and even new contracts proposed by existing exchanges as well as changes in margin requirements, price limits, and any significant changes in trading procedures. Violations of futures regulations can be subject to governmental prosecution. In addition, futures markets are far more transparent than forward markets. Futures prices, volume, and open interest are widely reported and easily obtained. Futures prices of nearby expiring contracts are often used as proxies for spot prices, particularly in decentralized spot markets, such as gold, which trades in spot markets all over the world.
In spite of the advantages of futures markets over forward markets, forward markets also have advantages over futures markets. Transparency is not always a good thing. Forward markets offer more privacy and fewer regulatory encumbrances. In addition, forward markets offer more flexibility. With the ability to tailor contracts to the specific needs of participants, forward contracts can be written exactly the way the parties want. In contrast, the standardization of futures contracts makes it more difficult for participants to get exactly what they want, even though they may get close substitutes. Yet, futures markets offer a valuable credit guarantee.
Like forward markets, futures markets can be used for hedging or speculation. For example, a jewelry manufacturer can buy gold futures, thereby hedging the price it will have to pay for one of its key inputs. Although it is more difficult to construct a futures strategy that hedges perfectly than to construct a forward strategy that does so, futures offer the benefit of the credit guarantee. It is not possible to argue that futures are better than forwards or vice versa. Market participants always trade off advantages against disadvantages. Some participants prefer futures, and some prefer forwards. Some prefer one over the other for certain risks and the other for other risks. Some might use one for a particular risk at a point in time and a different instrument for the same risk at another point in time. The choice is a matter of taste and constraints.
The third and final type of forward commitment we will cover is swaps. They go a step further in committing the parties to buy and sell something at a later date: They obligate the parties to a sequence of multiple purchases and sales.
The concept of a swap is that two parties exchange (swap) a series of cash flows. One set of cash flows is variable or floating and will be determined by the movement of an underlying asset or rate. The other set of cash flows can be variable and determined by a different underlying asset or rate, or it can be fixed. Formally, a swap is defined as follows:
A swap is an over-the-counter derivative contract in which two parties agree to exchange a series of cash flows whereby one party pays a variable series that will be determined by an underlying asset or rate and the other party pays either (1) a variable series determined by a different underlying asset or rate or (2) a fixed series.
As with forward contracts, swap contracts also contain other terms – such as the identity of the underlying, the relevant payment dates, and the payment procedure – that are negotiated between the parties and written into the contract. A swap is a bit more like a forward contract than a futures contract in that it is an OTC contract, so it is privately negotiated and subject to default. Nonetheless, the similarities between futures and forwards apply to futures and swaps and, indeed, combinations of futures contracts expiring at different dates are often compared to swaps.
As with forward contracts, either party can default but only one party can default at a particular time. The money owed is always based on the net owed by one party to the other. Hence, the party owing the lesser amount cannot default to the party owing the greater amount. Only the latter can default, and the amount it owes is the net of what it owes and what is owed to it, which is also true with forwards.
Swaps are relatively young financial instruments, having been created only in the early 1980s. Thus, it may be somewhat surprising to learn that the swap is the most widely used derivative, a likely result of its simplicity and embracement by the corporate world. The most common swap is the fixed-for-floating interest rate swap. In fact, this type of swap is so common that it is often called a “plain vanilla swap” or just a “vanilla swap,” owing to the notion that vanilla ice cream is considered plain (albeit tasty).
Let us examine a scenario in which the vanilla interest rate swap is frequently used. Suppose a corporation borrows from a bank at a floating rate. It would prefer a fixed rate, which would enable it to better anticipate its cash flow needs in making its interest payments.10 The corporation can effectively convert its floating-rate loan to a fixed-rate loan by adding a swap, as shown in Exhibit 2.
EXHIBIT 2 Using an Interest Rate Swap to Convert a Floating-Rate Loan to a Fixed-Rate Loan
The interest payments on the loan are tied to a specific floating rate. For a dollar-based loan, that rate has typically been US dollar Libor.11 The payments would be based on the rate from the Libor market on a specified reset date times the loan balance times a factor reflecting the number of days in the current interest calculation period. The actual payment is made at a later date. Thus, for a loan balance of, say, $10 million with monthly payments, the rate might be based on Libor on the first business day of the month, with interest payable on the first business day of the next month, which is the next reset date, and calculated as $10 million times the rate times 30/360. The 30/360 convention, an implicit assumption of 30 days in a month, is common but only one of many interest calculation conventions used in the financial world. Often, “30” is replaced by the exact number of days since the last interest payment. The use of a 360-day year is a common assumption in the financial world, which originated in the pre-calculator days when an interest rate could be multiplied by a number like 30/360, 60/360, 90/360, etc., more easily than if 365 were used.
Whatever the terms of the loan are, the terms of the swap are typically set to match those of the loan. Thus, a Libor-based loan with monthly payments based on the 30/360 convention would be matched with a swap with monthly payments based on Libor and the 30/360 convention and the same reset and payment dates. Although the loan has an actual balance (the amount owed by borrower to creditor), the swap does not have such a balance owed by one party to the other. Thus, it has no principal, but it does have a balance of sorts, called the notional principal, which ordinarily matches the loan balance. A loan with only one principal payment, the final one, will be matched with a swap with a fixed notional principal. An amortizing loan, which has a declining principal balance, will be matched with a swap with a pre-specified declining notional principal that matches the loan balance.
As with futures and forwards, no money changes hands at the start; thus, the value of a swap when initiated must be zero. The fixed rate on the swap is determined by a process that forces the value to zero, a procedure that will be covered later in the curriculum. As market conditions change, the value of a swap will deviate from zero, being positive to one party and negative to the other.
As with forward contracts, swaps are subject to default, but because the notional amount of a swap is not typically exchanged, the credit risk of a swap is much less than that of a loan.12 The only money passing from one party to the other is the net difference between the fixed and floating interest payments. In fact, the parties do not even pay each other. Only one party pays the other, as determined by the net of the greater amount owed minus the lesser amount. This does not mean that swaps are not subject to a potentially large amount of credit risk. At a given point in time, one party could default, effectively owing the value of all remaining payments, which could substantially exceed the value that the non-defaulting party owes to the defaulting
Banks prefer to make floating-rate loans because their own funding is typically short term and at floating rates. Thus, their borrowing rates reset frequently, giving them a strong incentive to pass that risk on to their customers through floating-rate loans.
It is possible that the notional principal will be exchanged in a currency swap, whereby each party makes a series of payments to the other in different currencies. Whether the notional principal is exchanged depends on the purpose of the swap. This point will be covered later in the curriculum. At this time, you should see that it would be fruitless to exchange notional principals in an interest rate swap because that would mean each party would give the other the same amount of money when the transaction is initiated and re-exchange the same amount of money when the contract terminates.
