What are Swaps? Financial Derivatives Tutorial

In todays video we learn about Swaps.

Learning all about finance and derivatives. in today’s video we’re going they? how do they work? who trades them? straight to a definition, let’s just firstly discuss the idea of the swap. for that they’re complicated and confusing, but in truth they’re neither of these more difficult than swaps. there is no complicated formula for valuing swaps or them and let’s think

About what they are. so when i teach this class at king’s college or queen mary university, i often start out imagine that you’re a university student after the exams you go out with a drink with your best friend from college. we’ll have one quick drink, and then we’ll go home you know, but the things are getting a bit sloppy. you turn to your friend and you no you are

By far the smartest person. you’re, everyone thinks, everyone says successful student. and you say to your friend, oh no no, you will be the most goes on and o,n and you know you decide to have maybe another drink while you friend. you’ve said to them you know what i have so much faith in you and how enter into an agreement with you what we’ll do is we’ll both go out and

We’ll month will sign over my paycheck to you you will sign over your paycheck to me transaction and i will with just cashing my own paycheck and your friend agrees a really good job you know things work out for you you’ve got a really top job lot of money but of course the problem is that you’re not really making a lot yours and your friend of course your friend actually

Was right there a lot of a job at a local restaurant you know they’re flipping burgers at the you know so you are at this point will say a couple of years into it you’re the know there’s there’s still you know flipping hamburgers so what happens well agreement that you entered into was just we didn’t know what they would be and we agreed at time zero that they were we

Start to see what the two cash flows will be and we see who wins and who do we price that once once the swap is running you know once things are are just going to grow at the rate of inflation for example which is probably it is and so all we need to do to price this transaction is we just need to of these two cash flows will be the amount you’d have to pay to get out of

See also  BeatTheBush Patreon Announcement | BeatTheBush

This agreement with your friend to do for five years you know so if we’re cash flows of your income over the next two years and their expected cash flows so now you know what a swap is and how it works but let’s see if we can come up derivative in which two counterparties exchange the cash flow of one party’s period of time stated in the agreement these cash flow streams

Are referred to cash flows are to be paid and how they’re calculated the cash flows are not exchanged between counterparties it’s just used as a reference from which inception at least one of the cash flows is an uncertain variable such as a benefit one of the two parties financially however both parties may explained in my earlier video which was called should companies

Use derivatives ibm and world bank entered into a swap agreement since then swaps have become swaps can be most easily understood as an exchange of loans consider two fixed rate and the other at a floating rate both would like to balance their reduce their overall interest rate risk or to speculate on the future direction there’s no need to exchange principal leaving only

The quarterly cash flows to premium or offer a discount on the original fixed borrowers rate depending original loans the original fixed rate plus the premium are – the discount the normal commercial operations of many interest rates or foreign exchange will take for example a us savings and loan them they then lend those deposits out as home mortgages in the united states

Floating rate loans in the united kingdom as a result a us-based savings liabilities this would lead to losses in a rising interest rate environment to market to convert either their liabilities to fixed rate or their manage their interest rate risk exposures however because swaps reflect swaps also became an attractive tool for other fixed income market participants the

See also  5 Shocking Financial Truths About The Wedding Industry

Term plain vanilla when used in finance usually signifies the most basic of an exotic in ermand which is a term used to describe interest rate swap which involves one counterparty paying a fixed rate to like libor and return by market convention the counterparty paying the the receiver see the diagram on screen right now which shows the two used as a basis for calculations

It is not actually transferred between the two this then allows us to calculate the amount of the payments based on the two of the period and paid at the end of the zero at inception the present value of the two legs of the swap must be equal rate is the one at which the two cash flows have an equal present value okay interest rate swap abc agrees to pay a fixed rate at

Four percent an xyz agrees dollars payments are semiannual and the maturity is three years you can see that since we don’t know the part that libor rates will actually take in the future will pay xyz two million dollars assume now that the three years has passed the note that the notional principal in this example $100,000,000 does not change to wire each other an identical

Amount of money at the outset it’s just a note that the interest rate swap allows the counterparties to do the same thing from fixed to floating or vice versa in the example abc switched its borrowing switched its borrowing from fixed to floating believing that rates would fall industry has grown in order to facilitate swap transactions initially over time they moved to a

Model where they make markets in interest rate swaps risk of counterparty default the risk of mismatched entry timing to each leg and find themselves exposed to the very risks their customers are trying to contact list and stand ready to find a suitable counterparty first swap upon they have found a very likely counterparty for their services a swap financial intermediaries

See also  Budgeting Basics | BeatTheBush

And fulfill all may also take risk positions in swap transactions by becoming an actual party customer but then they’ll quickly see per offset that risk in the market the are traded over the counter but some types of swaps are also traded on exchange and your eggs so who trade swaps then let’s look at five different their interest rate exposure or to more closely match

Their assets or income traders away to speculate on movements in interest rates while reducing the bond to speculate on a fall in interest rates a trader could receive fixed in a the investor to put up as much capital number three portfolio managers interest reduce the duration of their portfolio they give portfolio managers a way of rate volatility long-dated interest

Rate swaps can be an effective tool in duration of a portfolio where the aim is to match the duration of assets with institutions are usually involved in a huge number of transactions involving institution to interest rate risk this risk can be managed using swaps number that gives them time to go out and find investors for the bonds once the bonds hedged the interest rate

Risk between the sales pitch for the bonds and the foreign exchange traders entered these agreements to work around british was negotiated in 1981 between the world bank and ibm ibm at the time had large bank worked out an agreement in which the world bank borrowed dollars in the over ibm swiss franc and deutsche mark obligations the swap market has grown globally was 318

Trillion dollars at the end of 2017 according to the bank for international swaps and derivatives association – the global trade association i’ll probably do a video on the is de master agreement sometime soon value is outstanding so that’s it you made it all the way to the end so do hit button comment below if there are any additional topics you’d like to see me

Transcribed from video
What are Swaps? Financial Derivatives Tutorial By Patrick Boyle

Scroll to top