Swaps Fundamentals

Highlights

Swaps are the most prevalent derivatives used by corporations, and financial institutions to exchange a set of future cash flows with another set. The market participants carry them in balance sheet or off-balance sheet, and their gigantic volume has always been a point of concern for regulatory bodies and central banks. Considering that FRA is based on the exchange of one cash flow with another one, swap is set of FRAs.

In this course, we will discuss the basic financial theories and concepts relevant to swaps. The pricing of swaps will also be explained and demonstrated through many examples. We then look into Interest Rate including Forward and Overnight Index Swap (OIS) swaps, Equity, Cross-Currency, Quanto, Credit Default, and Asset Swaps.

The Credit Default swaps ("CDS") are now extremely popular and trade billions of dollars every day. While they were originally developed to hedge the risk of fixed income products, they are now used to take a position without trading the underlying which can be a particular bond of a corporation or a country. Interestingly, the size of a particular CDS can many times be larger than the size of the underlying because they are cash-settled. Therefore, we will spend a good portion of our time on this subject.

Credit Default Swaps ("CDS") allow investors to swap the credit risk of a corporation, index, or a country with other investors. CDS market started in 1990's and drastically grew until 2007 global crisis to a $60 trillion market. For comparison, the global equity and bond markets are about $80 and $90 trillion respectively. Considering the important role that CDS played in shaping the global crisis of 2007 and also the large trading loss at JP Morgan, the governments introduced more restrictions on the CDS market. CDS which were mainly traded as OTC products between brokers and clients, were then transformed to become more standard contracts clearing via central clearing counterparties.