The aim of swap contract is to bind the two counterparties to exchange two different payment stream over time, the payment being tied, or at least in part, to subsequent—and uncertain—market price developments. In most swaps so far, the prices concerned have been exchange rates or interest rates, but they increasingly reach out to equity indices and physical commodities. All such prices have risk characteristics in common, in quality if not degree. And for all, the allure of swaps may be expected cost saving., yield enhancement, or hedging or speculative opportunity.
Portfolio management requires financial swaps which are simple in principle, versatile in practice yet revolutionary. A swap coupled with an existing asset or liability can radically modify effective risk and return. Individually and together with futures, options and other financial derivatives, they allow yield curve and currency risks, and liquidity and geographic market considerations, all to be managed separately and also independently of underlying cash market stocks.
Growth of the SWAP Market:
In the international finance market most of the new products are executed in a physical market but swap transactions are not. Participants in the swap market are many and varied in their location character and motivates in exciting swaps. However, in general the activity of the participants in the swap market have taken on the character of a classical financial market connected to , and integrating the underlying money, capital and foreign exchange market.
Swap in their current form started in 1981 with the well-publicised currency swaps, and in the following year with dollar interest rate swaps. The initial deals were characterized by the three critical features.
The major dramatic change has been the emergence of the large banks as aggressive market makers in dollar interest rate swaps. Major US banks are in the business of taking credit risk and interest rate risk. They, therefore, do not need counterparties to do dollar swaps. The net result is that spreads have collapsed and volume has exploded. This means that institutional investors get a better return on their investments and international borrowers pay lower financing costs. This, in turn, result in more competitively priced goods for consumers and in enhanced returns pensioners. Swap therefore, have an effect on almost all of us yet they remain an arcane derivative risk management tool, sometimes suspected of providing the international banking system with tools required to bring about destruction.
Although the swap market is now firmly established , there remains a wide divergence among current and potential users as to how exactly a given swap structure works, what risks are entailed when entering into swap transactions and precisely what “the swap market” is and, for that matter is not.
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