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THE BASIC SWAP STRUCTURES
The growth and continued success of the swap market has been due in no small part to the creativity of its participants. As a result, the swap structures currently available and the future potential structures which will in time become just another market ―norm‖ are limited only by the imagination and ingenuity of those participating in the market. None-the less, underlying the swap transactions seen in the market today are four basic structures which may now be considered as ‗fundamental‖. These structures are:
- the interest Rate Swap
- the Fixed Rate Currency Swap
- the Currency Coupon Swap
- the Basis Rate Swap
RISK OF INVESTMENT
The Webster‘s New Collegiate Dictionary definition of risk includes the following meanings: ―……… possibility of loss or injury ……… the degree or probability of
such loss”. This conforms to the connotations put on the term by most investors. Professionals often speak of ― downside risk” and “upside potential”. The idea is straightforward enough: risk has to do with bad outcomes, potential with good ones.
In considering economic and political factors, investors commonly identify five kinds of hazards to which their investments are exposed. They are:
Business and Financial Risk
Business risk and financial risk are actually two separate types of risks, but since they are interrelated it would be wise to discuss them together. Business risk, which is sometimes called operating risk, is the risk associated with the normal day- to-day operations of the firm. Financial risk is created by the use of fixed cost securities (that is, debt and preference shares). Looking at the two categories in a sources and uses context, business risk represents the chance of loss and the variability of return created by a firm‘s uses of funds. Financial risk is the chance of loss and the variability of the owners‘ return created by a firm‘s sources of funds.
To clarify this important distinction between business and financial risk, let us examine the income statement contained in Exhibit I. Earnings before interest and taxes can be viewed as the operating profit of the firm; that is, the profit of the firm before deducting financing charges and taxes.
Business risk is concerned with earnings before interest and taxes and financial risk is concerned with earnings available to equity holders. The two components of business risk signify the chance that the firm will fail because of the
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EarningBeforeInterestand Taxes (EBIT) 10,86.
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Interest 1,62, Depreciation 1,45, EarningsBeforeTaxes 7,79. Provision for taxation 3,80. EarningsafterTaxation 3,99.
Preferred Dividend ……… Earningsavailableto equity holders 3,99,
Number of equity shares 43,77, Earnings per share 9,
Purchasing Power Risk
Whenever investors desire to preserve their economic position over time, they utilize investment outlets whose values vary with the price level. They select investments whose market values change with consumer prices which compensates them for cost of living increase. If they do not, they will find that their total wealth has been diminished. Inflation is an economic crippler that destroys the economic power of investors over goods and services. In essence, investors have to be concerned with the command that their invested money has over goods and services on a continuing basis. In fact, we have been living with increasing consumer prices for many years.
The relation between the market rate earned r , the rate of price change AP/P, and the investor‘s rate of change in real purchasing power X is shown in the equation (1) :
losses are the result of changes in the general tenor of the market and are called market
risks.
The market risk in equity shares is much greater than it is in bonds. Equity shares value and prices are related in some fashion to earnings. Current and prospective dividends, which are made possible by earnings, theoretically, should be capitalized at a rate that will provide yields to compensate for the basic risks. O n the other hand, bond prices are closely related to changes in interest rates on new debt. Equity prices are affected primarily by financial risk considerations which, in turn, affect earnings and dividends. However, equity prices may be strongly influenced by mass psychology, by abrupt changes in financial sentiment and by waves of optimism or pessimism. Whenever emotions run high, speculators and gamblers crave action. They cannot refrain from entering the market arena as their greed for profits becomes their overpowering motivation. They do not hesitate to analyze the market environment. They do not base their judgements on an accurate evaluation of the underlying factors. Instead, they rush into the market and distort prices beyond any semblance of value. Greed pushes prices up, and fear drives them
down. In short, the crux of the market risk is the likelihood of incurring capital losses
from price changes engendered by a speculative psychology.
Interest Rate Risk
A major source of risk to the holders of high quality bonds is changes in interest
rates, commonly referred to as interest rate risk. These high-quality bonds are not subjected to either substantial business risk or financial risk. Consequently, they are referred to as high-quality bonds. But since they are high-quality bonds, their prices are determined mainly by the prevailing level of interest rate in the market. As a result, if interest rates fall, the prices of these bonds will rise, and vice versa.
Interest rate risk affects all investors in high quality bonds regardless of whether the investors hold short-term or long-term bonds. Changes in interest rate have the greatest impact on the market price of long-term bonds, since the longer the period before the bond matures, the greater the effect of a change in interest rates. On the other hand, changes in interest rates will not have much of an impact on the market price of short- term bonds portfolio may fluctuate markedly from period to period, as interest rates change. Consequently, changes in interest rates affect investors in long-term as well as in short-term bonds.
Social or Regulatory Risk
The social or regulatory risk arises where an otherwise profitable investment is impaired as a result of adverse legislation, harsh regulatory climate, or in extreme instance nationalization by a socialistic government: The profits of industrial companies may be reduced by price controls, and rent controls may largely destroy the value of rental property held for income or as a price-level hedge. The social risk is really political and thus unpredictable, but under a system of representative government based on increasing government intervention in business affairs, no industry can expect to remain exempt from it.
Other Risks
Other types of risk, particularly those associated with investment in foreign
securities, are the monetary value risk and the political environment risk. The investor who buys foreign government bonds or securities of foreign corporations often in an attempt to gain a slightly higher yield than obtained on domestic issues, runs the calculated risk of (1) a change in the foreign government and repudiation of outstanding debt, (2) nationalization of business, firms, that is, seizure by government, or (3) the desire but inability of the foreign government or corporation to handle its indebtedness. The investor should weigh carefully the possibility of the additional risks associated with foreign investments against his expected return, either in the form of interest or dividends or capital gains, when investing in foreign securities rather than domestic securities.
