In Finance, What is Telephone Switching?

Financial swaps are mainly carried out through the over-the-counter market. The two parties to the transaction sign swap agreements to exchange different contents or cash flows of different natures in a certain period of time

Financial swap

The main functions of financial swaps are:

1.Financial swaps can be conducted between markets around the world

Although the financial swap has a short history, the variety innovations are changing with each passing day. In addition to the traditional

The development of financial swaps has not stopped for a moment since its creation, so its characteristics are also developing dynamically. In summary, the characteristics of financial swaps are mainly manifested

Diversification of financial swap varieties

The most basic types of financial swaps refer to Currency Swap and Interest Rate Swap. The former refers to the agreement between the two parties to agree to exchange the payment of principal and interest in different currencies on the basis of expectations of future exchange rates. . The main points include: the two parties exchange the principal at the agreed exchange rate; exchange of interest payments every six months or annually based on the agreed interest rate and the principal; when the agreement expires, the original principal is exchanged at the predetermined exchange rate Switch back, etc. The latter refers to the exchange of interest payments on the same currency by the two parties at an agreed date and interest rate based on expectations of future interest rates. The most basic form of interest rate swap refers to the swap of fixed interest rate and floating interest rate, that is, one party exchanges fixed rate debt for floating rate debt and pays floating interest rate; the other party exchanges floating rate debt for fixed rate debt and pays fixed interest rate. On this basis, new types of financial swaps continue to appear, the most typical being cross currency interest rate swaps, so that the swaps form a complete category (see Table 1) and present a variety of characteristics.

Table 1 Basic types of interchange

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Standardization of financial swap structure

In the early stages of the development of financial swaps, several factors prevented their further development. For example, credit risk in swaps is difficult to grasp, and there is a lack of generally accepted trading rules and contract texts. To this end, in February 1985, focusing on banks and securities companies active in the swap market, many swap participants established the International Swap Exchange Association (International) Swap Dealer's Association (ISDA for short), and published a famous paper on the standardization of swap business by the member of the association, Christopher Stoke, in the International Financial Regulations Review, and drafted the standard text "Interest Rate and Currency Swap Agreement". The purpose of the agreement is to unify the terms of transactions, develop a standard contract format, and unify the calculation of interest. The agreement requires that both parties to the transaction sign such a "master agreement" before (or after) the first swap transaction, and that various terms be discussed, modified, and supplemented. This saves a lot of time in preparing and discussing the text for each subsequent swap transaction. Under the "Master Agreement", each swap transaction between the two parties requires only one letter or telex to determine the transaction date, effective date, expiry date, interest rate, nominal principal amount, settlement account, etc. of each swap Can be concluded. So far, most banks and investment banks in the world have become members of the association, which has greatly promoted the standardization of swap transactions. The implementation of this agreement marks that the financial swap structure has entered a standardization stage, which has created good conditions for the in-depth development of financial swap transactions and greatly improved transaction efficiency.

Diversification of financial swap participating institutions

The swap market participants include end users and intermediaries. End users refer to governments and their agencies in various countries, especially developing countries, banks and multinational companies worldwide, savings agencies and insurance companies, international agencies and securities companies, and so on. The basic purpose of their participation in swaps is to obtain high-yielding assets or low-cost financing, implement effective management of assets and liabilities, avoid interest rate or exchange rate risks in normal economic transactions, and carry out arbitrage and arbitrage. Intermediaries mainly include investment banks and commercial banks, securities trading centers in the United States, Britain, Japan, Germany, Canada and other countries. The important purpose of their participation in swaps is to obtain fee income from the business undertaken and profit from trading opportunities. The development of swap transactions has made the above two types of institutions more and more overlap in practice. Many agencies are actively involved in the activities of both parties, that is, the same agency may be either an end user or an intermediary agency. In particular, a large number of large commercial banks and investment banks and reputable multinational companies often use their advantages of high reputation, wide information, and multiple institutions to directly exchange, thus greatly reducing the need for intermediary institutions. It is important to point out here: First, commercial banks or investment banks often regard swaps as tradable securities, and they have always been at the forefront in standardizing swap contracts and market time, and have strengthened the swap market. fluidity. Second, during the development of swaps, some intermediary agencies, especially financial institutions, began to act as market makers. The main reasons are: First, the swap market has gradually evolved from a market that emphasizes new securities arbitrage to a market for corporate asset-liability portfolio management services, which requires the swap market to be liquid. The market maker's practice of providing two-way quotes for swap transactions creates conditions for users to engage in reverse swaps or cancel swaps at the current market interest rate, thereby promoting the use of swaps in the management of corporate asset and liability portfolios. Second, the emerging multi-product portfolio trend of financial products has promoted the development of market makers. Financial engineering can continuously combine and decompose forwards, options, swaps, and commodities and equity instruments to create tools more suitable for asset and liability management needs. Because financial products have different characteristics, it is difficult for each counterparty to engage in a fully offset transaction, so the role of market makers in the structural design, pricing, and risk aversion of such products is increasing. The third is to make more profits. A market maker is a price maker in the swap market. It can make a profit by dividing large transactions into small ones and seizing trading opportunities for trading. Fourth, for financial institutions, as the profits of risk-free traditional financial services are gradually declining, for the purpose of increasing operating profits, they act as market makers to develop their own businesses.

Derivatives of financial swap products

Combining financial swaps with other financial instruments can generate many complex swap derivatives, such as the combination of options to generate swap options, the combination of swaps and futures to generate swap futures, and the combination of stock indexes to generate stock index swaps. . Taking swap options as an example, it refers to options with fixed interest rates paid in swap transactions. The swap option contract gives the option buyer the right to choose whether to perform the swap in accordance with the conditions agreed in advance on a specified date or before a specified date. This right can be exercised within a specified period or can be waived. It can be seen that swap options provide great flexibility for asset management of financial institutions and enterprises. Because before swap options did not occur, people could only use interest rate hedging for over-the-counter option trading or over-the-counter option trading to pay bonds. There are many types of swap options, such as redeemable swaps, deferred swaps, sellable swaps, and cancelable swaps. Their transaction properties are the same, and they are based on call and put options. Developed. Another example is stock index swap, which means that the two parties to the swap have reached an agreement to swap a payment linked to a stock index change with a payment based on a short-term interest rate index. It is mainly used to replace direct investment in the stock market, but users also bear the risk of stock index changes. Its basic structure is shown in Figure 1:

Figure 1 Basic Structure of Stock Index Swap

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When the stock index rises, the bank pays investors the stock index + spread (basis point)

Investors pay banks index of stocks-spread (basis point) when stock indexes fall

USD LIBOR

USD LIBOR + 35 basis points

Asset swap is also an important form of swap developed on the basis of basic swap. Asset swap refers to repacking a fixed rate security into floating rate securities, or repacking a floating rate security into fixed rate securities, or The debt service currency of the security is converted into another currency. Asset swaps can bring higher returns to investors and further diversify the asset portfolios of financial institutions, reducing the risk of asset portfolios.

Financial swap business off-balance sheet

Transactions of financial derivatives do not constitute the assets and liabilities of the parties involved, and are off-balance sheet business. Financial swaps are an important part of financial derivatives, and of course their business has the characteristics of off-balance sheet. In other words, financial swaps are independent of various borrowings or investments in terms of time and financing, that is, the specific borrowing or investment behavior has nothing to do with the interest rate basis and exchange rate basis in the swap. This feature determines that financial swaps can be used to evade foreign exchange control, interest rate control, and tax restrictions, to obtain huge profits to expand capital without increasing liabilities, and to increase capital adequacy and other purposes. This characteristic also shows that under the premise of the existence of risks in financial swaps, if the financial swaps are not properly disclosed in the balance sheet, it will not be able to fully and accurately reflect the operating behavior and risk status of economic entities.

Financial swap risk management throughout the process

As an important financial derivative product, the main reason for financial swap is to avoid financial risks. However, in the development process, financial swaps also have many risks. Therefore, strengthen risk management, reduce the amount of risks as much as possible, and prevent risks from becoming actual losses, which runs through the entire process of the swap business. From the perspective of the causes of risks, swap risks mainly come from: first, economic factors, mainly changes in interest rates and exchange rates; second, political factors, such as changes in a country's political system, cause large fluctuations in financial market prices; Third, operational factors, such as excessive speculation and inadequate internal control mechanisms; fourth, other factors, such as natural factors and social factors. From the perspective of risk performance, because the main participants of the swap include intermediaries and end users, the risks they face are different. For intermediaries, the first risk they face is credit risk. Once an intermediary agency is a market maker, it also faces market risks when it holds an uncorresponding position. Therefore, credit risk and market risk are the main risks of swap intermediaries. Other risks, such as national risk, legal risk, and settlement risk, also affect intermediary institutions. For the end user, in the swap transaction involving the intermediary, if another end user defaults, the contract between the end user and the intermediary is still valid. Therefore, as an end user, you can ignore credit risk and take market risk as the main risk that needs to be monitored and managed. From the perspective of risk management strategy: First, the swap contract is valued throughout the process. The valuation of the swap contract occurs after the swap contract is signed. It calculates the value of the positions already held and their changes, with the purpose of monitoring possible profit and loss and risk management. Only by performing accurate valuation of swap contracts, and continuously adjusting your own expectations according to changes in market conditions during the implementation process, can we prevent targeted expansion of risks and minimize risks. The second is to adopt different strategies for different risks: Generally speaking, the measures to prevent credit risk are to select companies that can perform as scheduled, regardless of changes in market exchange rates or interest rates; to prevent market risks requires accurate Predict the future market exchange rate or interest rate trend, or prevent the further expansion of market risk losses by signing another swap agreement that is opposite to the original agreement, or slow down the market by transferring or selling the original swap agreement Risk loss, etc.

Figure 2 Nominal principal of outstanding interest rates and currency swaps (US $ 1 billion)

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Unbalanced development of financial swaps

As two basic forms of swaps, currency swaps occur before interest rate swaps, and each has its own advantages and characteristics, but it shows obvious imbalances in its development process. The development of interest rate swaps is much faster than currency swaps and has become the mainstream of the swap market (see Figure 2). The main reason is that the international borrowing market, especially the European dollar market, is very broad. At the same time, from the perspective of the internal structure, compared with interest rate swaps, because currency swaps involve a series of swaps of different currency principals and interests, the currency swap agreement usually takes longer to achieve, and the production of documents The aspects are also more complicated. From the perspective of new products, the development of the two also shows an imbalance: because currency swaps involve the swap of different currency principals and a series of different currency interests, there are fewer new products in the international financial market, mainly including Fixed-rate currency swaps, floating-rate currency swaps, and installment currency swaps; new products of interest-rate swaps are emerging, such as zero-to-floating interest rate swaps, floating-to-floating interest rate swaps, and redeemable interest rate swaps , Sellable interest rate swap, deferred interest rate swap, forward interest rate swap, etc.

Source: BIS

Internationalization of financial swap supervision

Because financial swap is an off-balance sheet business, and it is an over-the-counter transaction, standard contracts can be negotiated and modified, so its transparency is low. So far, regulatory agencies in various countries have not proposed a very effective way specifically for the supervision of financial swaps. At the same time, a swap transaction often involves different institutions in two or more countries, and it is bound to require the internationalization of swap supervision. As mentioned earlier, the main risks of swap transactions include credit risk and market risk. Therefore, the supervision of swap transactions is actually the supervision of the above two risks. Initially, regulators focused on the supervision of credit risk, and with the gradual development of transactions, the regulators found that swap transactions often have a great impact on the bank's operating activities. As a result, they are increasingly focusing on market risk as a regulatory focus. In the international supervision of swap transactions, the BIS and the Basel Committee have played a significant role. For example, the Basel Accord, the core standard for international capital measurement and capital adequacy ratios issued by the Bank for International Settlements and the Basel Committee, aims to establish a unified framework for determining bank capital adequacy ratios internationally to help banks Off-balance sheet business (including swaps and derivatives transactions) is used to offset the credit risk assumed by them.

China's enterprises and financial institutions have only been involved in financial swap transactions in recent years, and are currently limited to simple interest rate swaps and currency swaps. The main reasons are: the risk management system of China's relevant institutions is not complete, the professional level of relevant personnel is not high, and the country s foreign exchange controls are relatively strict on a macro level. With China's entry into the WTO, China's economy is gradually integrated into the world economy, and financial derivative products commonly used in the world will soon enter China, and financial swaps will no longer be on paper. However, when using financial swaps in China, we must fully learn from the development experience of international financial swaps, and according to the realities of our country, we must make gradual progress; we must fully realize that financial swaps are a "double-edged sword", and we must strictly regulate and strengthen internal control And external regulation.

Expansion of financial swap function

There are two basic economic functions of swap transactions: one is to arbitrage between global financial markets, thereby reducing the financing costs of fundraisers or increasing the return on assets of investors, and promoting the integration of global financial markets; The second is that the swap transaction improves the management efficiency of interest rates and currency risks. That is, after the borrower or investor obtains a loan or invests, they can change the interest rate basis or currency type of their existing liabilities or assets through swap transactions. Profit from currency or exchange rate changes. With the development of swap transactions, its functions have gradually expanded, as shown in the following: First, the price discovery mechanism has been improved. The prices formed by financial swaps reflect all available information and the expectations of different traders, enabling future asset prices to be discovered. Second, financing channels have been broadened. By using financial swaps, fundraisers can raise funds in their own familiar markets and achieve their respective goals through swaps, without the need to seek financing opportunities in markets they are not familiar with. Third, investment bankers can use swaps to create securities. Since most swaps are traded over-the-counter, they can evade controls in foreign exchange, interest rates, and taxes. At the same time, swaps have greater flexibility, enabling investment bankers to create a series of securities. Fourth, gain speculative gains. With the continuous development of swaps, some professional traders have begun to use their professional advantages to correctly predict interest rates and exchange rates and use swaps to speculate. Once the market volatility is large, and its judgment is correct, the income is huge.

Complicated financial swap pricing

The price of the swap is mainly expressed by the interest rate and exchange rate level that the willingness to pay when swapping. In the international financial market, the main factors affecting the swap price are: the overall market interest rate level, exchange rate level and its fluctuation range and change trend when the swap is in progress; the principal amount and term of the swap; the swap parties' own Capital status and asset-liability structure; credit status of swap partners; possibility of swap contract hedging. Due to the influential factors of the swap price and the different methods used to calculate the return in the pricing process, the pricing process is more complicated, especially the pricing of derivatives for swap transactions is more complicated. In general, swap pricing mainly includes: First, based on the theoretical prices of forward and option contracts, the specific pricing technology of forward and option contracts is part of the swap pricing process. Pricing swap products using this method mainly involves pricing techniques such as forward contract pricing, option contract pricing, and up-and-down parity that reflects the specific mathematical relationship between forward and option contracts. Each of these aspects is very complicated. Second, the opportunity to arbitrage the capital market through swap transactions creates these opportunities by organizing these transactions at theoretical prices that are better than forwards or options. The price of any kind of financial product in the capital market arbitrage that is better than the forward or option theoretical price will cause the prices of all other instruments to be adjusted accordingly in a very short period of time. Therefore, the inherent relationship between various financial products and the arbitrage behavior caused by the price inconsistencies determine the adjustment of swap pricing. Although in terms of theoretical concepts, forward prices and financial arbitrage can be used to illustrate the pricing of financial swaps. But from the current point of view, financial arbitrage has become the main method of swap pricing, the main reason is that financial arbitrage can save costs for swap participants.