Template:M intro isda a swap as a loan: Difference between revisions

The difference between customer and borrower is ''who is economically borrowing''.   

“Hang on, though, JC: you yourself say a swap is a bilateral contract. How can that be so? Does it not follow that if the ''customer'' changes its position, the dealer must be doing so too?”  

The dealer ''provides'' exposure without taking any itself. It thereby earns a commission. This is all the excitement the dealer wants. The dealer hedges that market risk away. Without no market risk, the dealer is left with only customer ''credit'' exposure. ''As it would have'' ''in a loan''. (Spoiler: the similarities don’t end there.)

Ok: but how does that fleeting resemblance turn a bilateral swap into a “synthetic loan” from the dealer to the customer?

Imagine the JC’s in-house [[hedge fund]], [[Hackthorn Capital Partners]] holds USD10m of that redoubtable stalwart of legal [[Thought leader|thought-leader]]<nowiki/>ship [[Lexrifyly]], and wants to get exposure to the fabulous new [[Legaltech startup conference|legaltech start-up]], [[Cryptöagle]].

(i) ''sell'' [[Lexrifyly]] and ''buy'' [[Cryptöagle]] — this is an outright long investment;

(ii) ''hold'' [[Lexrifyly]] and ''borrow'' to buy [[Cryptöagle]] — this is a financed investment;

(iii) ''hold'' Lexrifyly and ''get exposure to'' [[Cryptöagle]] via a swap — conventionally, not a financed investment. (''But...'')}}}}

For ease of argument, let’s say on the investment date, both [[Cryptöagle]] and [[Lexrifyly]] trade at USD1 per share, so both positions are for 10m shares. Here are the positions:

Notice how similar the loan and the swap are. Even though there is no physical loan, the investor’s payment profile is the same. It pays a floating rate, and has the USD10m notional value of the loan deducted from its pay-out. And like a loan, the [[equity swap]] gives Hackthorn exposure to [[Cryptöagle]] whilst keeping its exposure to [[Lexrifyly]], which Hackthorn uses to fund cashflows on its new capital asset.  

The floating rate Hackthorn pays is ''implied funding''. The dealer will only accept this if it is satisfied Hackthorn has enough capital to finance its swap payments and settle any differences at termination. This is the same risk calculation a bank would make on a loan.<ref>To keep it simple, I have ignored the scope for synthetic margin loan and rehypothecation.</ref>   

Provided the [[dealer]] knows what it is about, its main risk in running a swap portfolio is not therefore market risk — it should not have any — but ''customer credit'' ''risk''. Should a customer fail, the dealer’s book is no longer matched: its delta-hedge is now an outright long or short position.  

Ok; that’s a delta-one equity swap. But is this kind of [[synthetic equity swap|synthetic prime brokerage]] just an odd use case? Aren’t “normal” swaps truly bilateral and less “lendy” in nature? How about good old fashioned [[Interest rate swap|interest rate swaps]]? Surely ''paying'' a fixed rate, while ''receiving'' a floating rate, has none of these same characteristics of borrowership and loanery about it?  

The first point to make here is that in the real universe of actual, non-synthetic investments, fixed or floating rate cashflows ''do not exist independently of a principal investment''. (This is just as true of dividend streams on equities). This is because they are necessarily ''income'' on a capital investment.   

Oh, sure, you could sell a strip of [[coupon]]<nowiki/>s off a [[Debt security|bond]]: okay. But to do that, there must first ''be'' a bond, and you have to buy it, cut it up and sell the stripped bond back into the market. Once you’ve done that, you have your disembodied interest cashflow all right, but you also have unleashed this weird, mutilated, principal-only instrument that flaps around the market at a heavy discount to a fully-limbed equivalent, sort of like Weird Barbie or one of those intercised kids with no daemon in ''His Dark Materials''.  

It was only once the [[Children of the Woods|Children of the Forest]] wrought their wristy magic on the [[First Men]] in the dark thickets of [[Bretton Woods|Woods of Bretton]] that the ways of the [[Single agreement|Single Agreement]] came into common understanding. Only then were leaden, earth-bound notions of principal swept away; the swap market took wing upon the nuclear power of infinite leverage. Income flows could bust free of their leaden principal host and frolic in ISDA’s glittering starlight.

In this ''synthetic'' world we have the mathematical tools to ''hypothetically'' isolate income from the assets which generate it, and trade the income streams as discrete instruments, but at some point, they must intersect with real-world instruments, ''because that is what they are derived from''. For a customer to take on a derivative position, someone else, somewhere in the linear chain of financial instruments hedging that exposure must, at some point, buy a real-world hedge. Including its principal. ''And that must be financed''.  

If you want a [[floating rate]] on a notional of a hundred bucks, you pony up a hundred bucks and buy a floating-rate note. That means selling down an asset you already have. If you don’t want to sell down that asset, you can borrow the hundred bucks at a fixed rate from the dealer who is selling you the floating rate note, pay that fixed rate out of your assets, and bingo: the principal on the note and your loan cancel out and ''you have an interest rate swap''.  

One last way to look at this: an [[interest rate swap]] is a levered investment in a fixed income asset. Interest rate swaps are, in this sense, “synthetic fixed income prime brokerage”: a [[margin loan]] to buy a fixed income asset.

We can see this by considering the parties’ respective economic positions before and after trading. The customer changes its net position; the [[dealer]] does not. Swapping a fixed cashflow for a floating one is to ''keep'' the “asset” funding that fixed cashflow, and to borrow the funds required to buy the new floating-rate asset. Because that borrowing has the same principal amount as the purchased floating-rate asset, the principal amounts cancel out, and the customer left with just the floating rate cashflow, for which it must pay the fixed rate cashflow it has agreed.