Definition of Swaps
Swaps refer to the exchange of one financial instrument for another between the concerned parties. This exchange therefore would take place at the predetermined time as it would be specified in the contract (Chumpong et al. 2022). Swaps are not exchange oriented and are observed to be traded over the counter, usually dealings are oriented through banks. The objective of a swap is to change one payment scheme into another one having different nature, which would be more suitable to the objectives and needs of the parties. The parties could be investors, retail clients or large companies. Swaps are often used because a domestic firm could usually receive better rates compared to the foreign firms. Currency swap is considered a foreign exchange transaction and as such they would not be legally required to be shown on the balance sheet of the company. Therefore, in simple terms, swap is the derivative contract where one party exchange or swap the cash flows or value of one asset for another (Hashmi, 2023). For example; a company that have paid a variable interest rate might swap the interest payments with another company that would then pay the first company at the fixed rate. The motivation for using swap contracts would fall into two basic categories such as; commercial needs and comparative advantages. The normal business operations of certain firms that would lead to specific types of currency interest rates having the exposure that swaps could alleviate. The mismatch between assets and liabilities could cause significant difficulties (Salmon and SenGupta, 2021). The bank would be using a fixed-pay swap that is to pay a fixed rate and receiving a floating rate. That would have the purpose of converting the fixed rate assets into floating rate assets, which would match well with the liabilities having floating rate.
Impact of Swaps on USA Market Crash in 2008
Credit default swaps have played significant role in financial crisis during 2008. Prior coming to the discussion on the impact of Swaps on USA Market crash during 2008, it would be necessary to understand Credit Default Swaps or CDS. A credit derivative known as a credit default swaps (CDS) offers the buyer protection against default and related other risks. Until the time of credit maturity date, the buyer of the CDS would be making periodic payments that are also to the seller (Wybieralski, 2020). The seller promises in the agreement that, in the event of the debt issuer’s default, they would be paying the buyer every premiums as well as interest due up to the maturity date. Significantly, in this accordance, it could be found that banks at larger size that have been traded in CSD’s had been forced for declaring bankruptcy when a large number of underlying credit instruments were observed to be defaulted at once. That has sent shockwave across the USA economy. The buyer of a CDS has made periodic payments to the seller until the date of the credit maturity (Youssef et al. 2021). In the agreement, the seller would commit that if the debt issuer defaults, the seller would be paying the buyer all premium as well as interests that would have been paid up to the maturity date. In this context, CDS are observed to be allowing investment banks for creating synthetic collateralised instruments with debt obligation that were bets on priced of the securitised mortgages. As these investment banks of USA had been highly entwined with global markets, the insolvency position of them caused global markets to be wavered as well as ushered during the period of 2007-2008 financial crises (He and Zhu, 2019). As a whole, companies that had traded in swaps were battered at the time of the financial crisis that USA market has faced during 2008.
Reference list
Chumpong, K., Mekchay, K., Rujivan, S. and Thamrongrat, N., 2022. Simple Analytical Formulas for Pricing and Hedging Moment Swaps. Thai Journal of Mathematics, 20(2), pp.693-713.
Hashmi, S.M., 2023. Sharia Ruling on Financial Risk Management in the context of Currency swap. ” Journal of Academic Research for Humanities”, 3(1), pp.290-297.
He, X.J. and Zhu, S.P., 2019. Variance and volatility swaps under a two-factor stochastic volatility model with regime switching. International Journal of Theoretical and Applied Finance, 22(04), p.1950009.
Salmon, N. and SenGupta, I., 2021. Fractional Barndorff-Nielsen and Shephard model: applications in variance and volatility swaps, and hedging. Annals of Finance, 17(4), pp.529-558.
Wybieralski, P., 2020. Cross-Currency Interest Rate Swap Application in the Long-Term Currency Risk Management. Annales Universitatis Mariae Curie-Skłodowska, Sectio H Oeconomia, 54(2), pp.113-124.
Youssef, E.K., ALSHAMSİ, M. and Jun, F.A.N., 2021. On pricing variance swaps in discretely-sampled with high volatility model. Results in Nonlinear Analysis, 4(2), pp.105-115.
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