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The CFTC defines swap agreement as any rate swap agreement, basis agreement, forward rate agreement, commodity swap, interest rate option, forward foreign exchange agreement, rate cap agreement, rate floor agreement, rate collar agreement, currency swap agreement, cross-currency rate swap agreement, currency option.
A a “swap agreement” is defined in 17 C.F.R. Section 35.1(b)(1) and an “eligible swap participant” is defined
in 17 C.F.R. Section 35.1(b)(2).
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The purpose of the swap transaction is to change the characteristic of the cash flow the asset without the need to liquidate the asset.
A Swap contract is considered a derivative product as the contract has no intrinsic value other than that which can be derived from the cash value or income stream value of an underlying asset or notional amount. These contracts are primarily traded in the unregulated over-the-counter (OTC) derivatives markets (Futures Trading Practices Act of 1992 / FTPA). OTC transactions are primarily entered into, and traded by, institutional traders. Also, most dealers in the swaps market are either affiliated with broker-dealers or futures commission merchants that are regulated by the SEC or the CFTC, or are financial institutions that are subject to supervision by bank regulatory agencies. (In the first quarter of 2008, the Chicago Mercantile Excahnge / CME has scheduled the introduction of the CME Swaps on Swapstream contract, the first interest rate swap to offer the OTC marketplace the full benefits and financial safeguards of central counterparty clearing. The contracts will be traded on the Swapstream sPro platform and centrally cleared through CME using its OTC clearing solution, CME Clearing360).
A Swap itself is a contractual agreement between two parties to exchange (swap) future payment streams based on differences in returns to different securities or changes in the price of some underlying item.
The U.S. Internal Revenue Service (IRS) have indicated that swap agreements do not constitute a qualified hedge under § 1.148-4(h)(2).
Commodity Swaps are an agreement to exchange fixed for floating commodity prices. The floating price can be an average price over a fixed period, or one price set between counterparties, on a future date.
In a standard swap (also referred to as the plain vanilla or generic swap), a fixed payment in USD is swapped for a 3 month or 6 month USD Libor payment. If both notional amounts were denominated in the Euro then a 3 month or 6 month Euribor payment would be used.
What is the logic for a bank to enter into a basis swap? A bank that extends a loan will fund that loan with either Eurodollar
deposits, borrowed federal funds or bank CDs (timed deposits). The spread between the asset index (loan) and the liability
indices (deposits or borrowed funds) can widen and narrow over the term of the loan. Thus, the basis swap can be used to fix
the spread between the asset and liability. The floating indices include:
Lease Rate Swaps are an agreement to exchange fixed for floating metal interest rates on a notional principal with a series of rate fixing dates and settlement dates. Interest is normally paid in arrears and can be compounded or settled at the end of each term.
LOCO Swaps are the purchase or sales of bullion in one location in exchange for bullion in another location with a premium/discount being payable.
Overnight Indexed Swaps (OIS) in the U.S. known as call-money swaps; allow users to hedge overnight rates when they are volatile or coming under pressure. Banks use them to manage short-dated funding gap risk off the balance sheet and at minimum credit risk. OIS is a fixed to floating rate interest swap, where the floating arm is tied to daily overnight rate reference. The term of the product, which is a true money market instrument, ranges from one week to one year. The two parties agree to exchange at maturity the difference between interest accrued at the agreed fix rate and interest accrued through compounding the floating index rate. There is no exchange of principal. A good hedge for repo and short-term funding desks.
Please see the Credit Derivatives Page.
An asset swap is an exchange of interests in at kease to separate, specif assets. The transaction is completed by using a Master Asset Swap Agreement.
Basis risk is the the risk that the normal relationship between indices or prices might change. For instance, there may be a mismatch between actual variable rate debt service and variable rate indices used to determine swap payments.
