Swaps Research Paper Starter


(Research Starters)

This article examines the swaps market including tax rate swaps, bond swaps, and other derivatives swaps. The origin of swaps is reviewed along with the various uses of securities swaps. The organizations involved in regulating and prompting swaps and the various roles they fulfill are explained. The applications and results of bond swaps are also reviewed along with examples of the types of organizations that have used bond swaps and the motivations behind these practices. Issues with regulating swaps and managing the swaps outcome for investors in light of the 2008-2009 economic crisis are also reviewed.

Keywords: 2008-2009 Economic Crisis; Bond Swaps; Derivatives; Financial Securities; Interest Rate Swaps; Municipal Bonds


In 2009 a survey conducted by the International Swaps and Derivatives Association (ISDA), found that 94 percent of the largest 500 companies in the world are using derivative instruments to manage and hedge their business and financial risks ("Over 94%," 2009). In addition, a large number of American companies use exchange-traded and over-the-counter derivatives to manage various risks. A review of derivatives use reported by the Dow Jones Industrial Average companies shows all 30 of the companies reported using interest-rate and exchange-rate derivatives while 23 of the 30 companies stated they used commodities derivatives and 21 companies mentioned their use of other derivatives ("Use of OTC Derivatives," 2009).

The value of derivatives, which include forward contracts, futures, and options, are determined by the value and the risk related to their underlying assets, which could include stocks, bonds, and even mortgages. The derivatives market, or swaps market, began in 1976 and by 2007 the notational value of the market was over three hundred trillion dollars (Hodgson, 2009). A swap is a privately negotiated agreement between two parties to exchange cash flows at specified payment dates during the agreed-upon life of the contract.

Interest Rate Swaps

An interest rate swap is an agreement to exchange interest rate cash flows, calculated on a notional principal amount, at specified payment dates ("Product Descriptions," 2009). Interest rate swaps first appeared in 1981, and very quickly they became widely used (Stewart & Trussel, 2006). In an interest rate swap each party's payment obligation is computed using a different interest rate and the notional principal is never exchanged ("Product Descriptions," 2009). The principal in an interest rate swap is called notational because it is the basis for calculating the interest and the principal is not exchanged at the end of the agreement. Thus, the principal is not at risk (Brown & Smith, 1993).

A "plain vanilla" swap typically refers to a generic interest rate swap in which one party pays a fixed rate and one party pays a floating rate. The London Interbank-Offered Rate LIBOR), the interest rate paid on interbank deposits in international money markets, is commonly used as a benchmark for short-term interest rates and as the floating rate on an interest rate swap ("Product Descriptions," 2009). Most swap market makers tend to be either commercial or investment banks (Brown & Smith, 1993).

Interest rate swaps generally have periodic review dates written into the agreement and often at the time of review, if the fixed rate exceeds the floating rate, then the party with the fixed rate of interest pays the other party the difference between the two rates. The payment may be calculated by the rate being multiplied by the notional amount for the specified interval of time that has passed. If, on the other hand, the floating rate exceeds the fixed rate, the party with the floating rate pays the other party the difference (Curley & Fella, 2009).

In the contemporary mortgage market mortgages are often connected to asset-backed securities. This securitization process uses the expected future payments from mortgages to support the value of securities that are sold to investors. These investors then have the right to portions of those future payments. The investor then assumes a portion of the risk that borrowers will not pay the mortgages and may default on loans (Gerding, 2009). In the case of mortgages backed by derivatives, any fluctuation in the expected cash flow stream of payments by borrowers can impact the profitability of the securities. Massive failure to repay home loans (as seen in 2008-2009) will of course affect the value of the securities. However, early repayment or refinancing of home loans at lower rates than what were being paid when the securities were issued can also negatively impact the future derived cash stream (Cortes, 2006).

Credit Rating Agencies (CRAs) are companies that grade securities and apply a credit rating based on an assessment based on the likelihood that a debt will be repaid. In the 1960s, CRAs started charging fees to debt issuers for rating their securities. The three largest CRAs are Standard & Poor's (S&P), Moody's Investors Service, and Fitch. Rating credit is an inherently subjective process which requires sound professional judgment. Credit rating professionals rely on vast amounts of quantitative and qualitative data. But a credit rating is only as sound as the research that goes into the rating and the qualifications and integrity of the raters (Coffee, 2009; Rom, 2009).

Bond Swaps

Investors swap bonds by selling one bond or set of bonds and buying another bond or set of bonds with the proceeds of the sale. Bond swapping can help investors improve the quality of their investment portfolio and potentially increase their total return on investment. As economic conditions change, investors may be able to obtain a higher rate of interest on the bonds they hold and change their tax liability when tax laws change. Bond issuers swap bonds as a process of issuing a new bond designed to replace an existing outstanding bond. The results of the swap can change the long term debt position of the issuer and in many cases also provide favorable terms for the investors (Kruger, 2000; "Bond Swapping," 2004).

Municipal Bonds

Since the 1970s local governments have relied on bonds to finance capital building projects including roads, schools, government buildings, and other urban economic development projects. During these 40 years the municipal bond market has grown in value to over $2 trillion. In 1982, Congress passed laws that required that municipal bonds be issued in a registered form in order to retain their tax-exempt status (Hildreth & Zorn, 2005).

Municipal bonds generally pay a specified amount of interest (usually semiannually) and return the principal to the investor on a specific maturity date. One key reason individual investors buy municipal bonds is the tax benefits; interest on the vast majority of municipal bonds is free of federal income tax, and if an investor lives in the state or city issuing the bond, they may also be exempt from state or city taxes on their interest income.

There are two common types of municipal bonds:

  • General Obligation Bonds
  • Revenue Bonds

General Obligation Bonds are issued by states, cities or counties which are backed by the full faith and credit of the government entity issuing the bonds. Revenue Bonds are backed solely by fees or other revenue generated or collected by a specific facility such as a toll bridge or road. Revenue bonds are not, however, backed by the full faith and credit of the government entity issuing the bonds. The creditworthiness of revenue bonds is determined by and depends on the financial success of the specific project they are issued to fund. Very few municipal bonds have gone into default, but defaults certainly can occur. Defaults tend to be higher for Revenue bonds than for General Obligation bonds, especially those that are used to fund private-use projects such as nursing homes, hospitals or toll roads ("Municipal Bonds," 2009).

Regulation of Municipal Bonds

The Municipal Securities Rulemaking Board (MSRB) makes rules regulating dealers who trade in municipal bonds, municipal notes, and other municipal securities ("Welcome to the MSRB," 2009). The MSRB was established by the United States Congress in 1975 to develop rules for regulating securities firms and banks involved in underwriting, trading, and selling municipal securities. The Board is composed of members from the municipal securities dealer community and the public and is subject to oversight by the Securities and Exchange Commission (SEC). The Board sets rules for:

  • Professional qualification standards;
  • Fair practice;
  • Recordkeeping;
  • Confirmation, clearance, and settlement of transactions;
  • The scope and frequency of compliance examinations; and
  • The nature of securities quotations ("About the MSRB," 2009).

Activities of securities dealers that sell municipal bonds are also subject to the rules set by the Financial Industry Regulatory Authority (FINRA) which mounted a comprehensive analysis of retail sales practices in the municipal securities market and has worked to promote investor protection. FINRA has also examined potential conflicts of interest, disclosure practices, and marketing methods of firms underwriting municipal securities involving swaps and derivatives ("FINRA Takes," 2009).

Reasons for Bond Swaps

Bond swaps occur for a variety of reasons. Issuing organizations including national governments, municipal and state governments as well as private issuers have a long history of bond swaps.

Home finance companies, especially those in the subprime loan market have needed to recapitalize and raise funds to pay existing note holders and to have funds to support the lending process. Bond swaps have helped such companies stay solvent during downturns (Hochstein, 1999). In other cases lending companies have made swaps in order to raise capital to expanding into new markets ("HKMC," 2000).

States, municipal governments, and specialized public organizations such as a turnpike authority have relied on bond swaps to control interest payments and consolidate previous bond issues into new bonds (Braun, 2003; Albanese, 2004; "BAA's," 2008). In addition, several national governments have also relied on bond swaps to control national debt, bolster currency, or improve their credit rating ("Bulgaria," 2002; "Lebanon," 2003; "Dominican Republic," 2005; " Philippines," 2006; "Uruguay," 2008).

International Organizations in the Derivatives Arena

The International Swaps and Derivatives Association (ISDA) represents participants in the privately negotiated derivatives industry. Founded in 1985, the ISDA has over 800 member institutions from 58 countries. The ISDA has worked to identify and reduce the sources of risk in the derivatives and risk management business and has developed the ISDA Master Agreement. The Master Agreement provides a framework for transactions in the over the counter (OTC) derivatives markets ("About ISDA," 2009).

The Securities Industry and Financial Markets Association (SIFMA) represents the interests of participants in the global financial markets on regulatory and legislative issues. Members include international securities firms, registered broker-dealers in the United States as well as asset managers ("The SIFMA Organization," 2009). SIFMA has supported the creation a central authority with oversight in all markets and of all systemically important market participants, the use of clearing houses for standardized transactions, and reporting through data repositories for all other OTC derivative transactions ("Over-the-Counter Derivatives," 2009).

The London Investment Banking Association (LIBA) is the primary trade association in the United Kingdom for companies and organizations that are involved in investment banking and wholesale securities. LIBA works with other trade associations that represent other aspects of the financial services industry, especially on issues that affect all of the participants and where joint activity is an efficient and effective use of resources ("About LIBA," 2009). LIBA is currently addressing issues of accounting, compliance, electronic commerce, financial regulation, and financial crime ("Current Issues," 2009).

Further Insights

Risk Management

Financial securities provide a means for individuals, investment banks, mutual funds, or retirement funds to invest money and to grow the value of their funds. Securities facilitate the process of attracting investors by providing an investment mechanism that is openly and publicly scrutinized by securities analysts and other investors. As the economic downturn of 2008 went from being a downturn to a near catastrophe it was apparent that the scrutiny of securities was not as rigid and comprehensive as it should have been (Bagtas, 2008). There is no doubt that many investment strategies were weak and that many investment analyses were wrong. Much of the economic analyses provided by industry analysts may have been compelling at one point but it became obvious that there was a lack of accuracy and perhaps even a lack of integrity (Savage & Gregory, 2007).

The complexity of global markets, technology innovation, economic interconnectedness and the volume of information necessary to analyze investment alternatives and make investment decisions have all increased over the last twenty years. The interrelationships between all of these aspects sometimes make it difficult to determine the impact that potential changes will have on investment strategies (Freeman, 2009; Freda, Arn, & Gatlin-Watts, 1999).

Recently, the financial industry's computer-based risk models have enabled financial institutions and securities firms to bring more complex derivatives products to investors. However, during the 2008-2009 economic downturn the massive failure of these models led to huge losses for investors and raised questions about how these products were being regulated (Coffee, 2009; Gerding, 2009).

The reliance on computer-supported analytical models used by many analysts quickly became criticized as the economic crisis worsened. Many of the analysts that were using the models and the firms they...

(The entire section is 6338 words.)