Title: 

Swap products and other structured products: Critical review of recent 
development as tool in Financial Risk Management applications.

by

Frédérik Arns

Month and Year: March 2006

Introduction  1
Swap Products  1
The Interest rate Swap  2
The Currency Swap  3
The Credit Default Swap  4
General Developments in the Swap Market  4
Structured Products: Concepts and Strategy  5
Invested Principal Protection Strategies  5
Principal Protected Strategy  6
Cushioned Principal Strategy  6
Principal Exposure Strategy  6
Yield Generation  7
Equity - linked Products  7
Interest - linked Products  8
Structured instrument pricing issues  8
Main developments in structured products  9
The role of individual investors  9
The role of corporate debtors  10
Conclusion  11
References  12
Appendices  17

Introduction

The increased volatility in the financial products world has raised concern about new possibilities of Risk Management leading into increased use of structured products. Credit derivatives are financial instruments to manage risk. They isolate such risk from the underlying financial asset (Gwilym and Meng, 2005). This essay, firstly, is going to examine the impact on swap products as a tool in Risk Management followed by an examination of key areas in structured products development that have experienced the strongest growth in the last decade. For both types, the authors will start outlining the current theory and pricing, followed by a demonstration of some characteristic applications in Financial Risk Management.

Swap Products

A swap describes an agreement among two entities to exchange cash flows in the future. This agreement defines the way in which the cash flows are calculated and the dates when they are exchanged. The calculation usually involves the future value of an exchange rate, an interest rate or another market variable. Since the first swap contracts were agreed in the beginning 1980s - evolving from parallel loan agreements¹ - the market has seen tremendous growth now being of central importance in the over-the-counter derivatives market (Hull, 2006).

Two umbrella terms of swaps classically exist in the market: Interest rate swaps and currency swaps. During recent years there is a new type of swap product evolving called: Credit Default Swap. The authors are going to discuss all three types of swaps individually well aware of the fact that more (like equity swaps, commodity swaps, volatility swaps etc) as well as combinations of these (like the Cross Currency Interest swap²) are also possible.

The Interest rate Swap

Interest rate swaps provide a well-situated tool to reduce interest rate risk in several ways. Generally interest rate swaps allow the borrower to enter into short-term borrowing transforming those into a long-term liability (McNulty, 1990).

There are four major theoretical explanations for the existence of interest rate swaps. Titman (1992) developed an asymmetric information model in which one entity believes to have lower future borrowing costs. This entity has incentives to borrow short term (floating) which it then swaps for fixed rate in order to reduce its interest rate expenses.

Wall (1989) develops a theory for the existence of swaps called: agency cost theory by combining underinvestment (Myers, 1977) with the asset substitution problem (Jensen and Meckling, 1976)³.

Bicksler and Chen (1986) use the theory of comparative advantage to explain the existence of swaps. Higher rated companies usually can borrow at lower rate than lower rated companies⁴. This theory is one usually students learn when first getting in contact with swaps as its assumptions allow an easy to understanding of interest rate swap use.

Finally Smith et al. (1986, 1988) developed the theory of expected future downsizing of the amount of debt of a company as a reason for the existence of swaps⁵. Firms expecting a decline in the most favourable amount of debt can consequently benefit from a swap without abandoning the issue of interest rate risk.

Saunders (1999) tested all these theories and found support for all of them whereas stronger support for the theories of information asymmetry and agency cost. In addition he finds that interest rate swap users “are significantly larger than their industry counterparts and have a significantly higher debt to equity ratio relative to nonusers” (Saunders, 1999, p. 77).

[....]

1 Parallel loan agreements were popular during the 1970s. For a detailed discussion and their relation to interest and currency swaps, see Abken (1991).

2 For an overview of several different types of single and cross-currency interest swaps and swaptations and there numerical valuation, see Dempster and Hutton (1997).

3 A firm that wishes to issue long-term debt usually has to pay a premium which is necessary to compensate for underinvestment and asset substitution. These premium payments can be evaded by issuing short-term debt and entering into a swap agreement paying fixed rate. Following this strategy the firm can fix a long-term interest rate evading the extra costs long-term debt usually burdens.

4 Following the suggestion of Bicksler and Chen (1986), the higher rated company should borrow long-term and the lower rated company should borrow short-term. Entering into a swap agreement in which the higher rated company pays floating and the lower rated company pays fixed is beneficial to both as they arbitrage the quality spread differential, and hence, have lower borrowing costs.

5 A company that has issued long-term debt at a fixed rate and wishes to reduce its debt outstanding might have to repurchase its debt at an amount far above fair market value. Issuing short-term floating debt and entering into a swap contract ensures the fact of a fixed long-term rate but decreases the cost of ‘repurchase’ tremendously as the company can just terminate the swap agreement – which usually is possible by paying the current fair market value of the swap - and stop issuing short-term debt.