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

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Repeat: in the real world, ''income cashflows depend on an income-generating asset''. Stands to reason. A rate with out principal is like a shadow without a boy.  
Repeat: in the real world, ''income cashflows depend on an income-generating asset''. Stands to reason. A rate with out principal is like a shadow without a boy.  
====Derivatives as engines of hypothesis====
Do swaps change all that? No: because at some point, swaps must be ''based in the reality from which they are derived''.
Do swaps change all that? No: because at some point, swaps must be ''based in the reality from which they are derived''.
====Derivatives as “engines of hypothesis”====
{{quote|
{{quote|
{{D|Derivative|/dɪˈrɪvətɪv/|n}}
{{D|Derivative|/dɪˈrɪvətɪv/|n}}
FINANCE: (of a product) having a value deriving from an underlying variable asset.}}
FINANCE: (of a product) having a value ''deriving from'' an underlying variable asset. (''emphasis added'')}}
 
{{smallcaps|When the}} [[Children of the Woods|Children of the Forest]] wrought their wristy magic on the [[First Men]], the [[Single agreement|Way of the One Agreement]] passed into common understanding. Only then were our leaden, earth-bound notions of “necessary principal” swept away.
 
Only then did the swap market take wing, upon the nuclear power of infinite [[leverage]]. Income could flow, at last, broken free of its leaden ''principal'' host, and could nudely frolic in ISDA’s glittering starlight.


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 necessary principal swept away. Only then did the swap market take wing, upon the nuclear power of infinite [[leverage]].  
The [[synthetic]] world is an alternative, magical realm. In it, there are imaginary tools with which we can do impossible things. ''Hypothetically',' we can isolate [[income]] from [[principal]] and trade them as discrete instruments. Normal rules of [[spacetime]] to not apply.


Income flows could, at last, bust free of their leaden principal host and frolic in ISDA’s glittering starlight.
But gravity is not banished; only ''postponed''. At some point, our [[swappist]] fantasia must alight on planet Earth and engage with real-world instruments, ''because that is what it is all derived from''. Ultimately, somewhere down the chain, someone needs to construct each enchanting payoff from grubby, real old-fashioned, corporate rights and obligations. Those rights and obligations will come with principal attached. And ''that'' must be financed.  


In this ''synthetic'' world we have the mathematical tools to ''hypothetically'' isolate income from the assets which generate it, and trade those 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 to earn [[floating rate]] on a notional of a hundred bucks, in the real world you pony up a hundred bucks and buy a floating-rate note. Ponying up cash means selling an investment you already own:<ref>Even free cash deposited with the bank is an investment: it is a loan to the bank.</ref> going off some other risk. If you don’t want to sell down that asset, you must ''borrow'' a hundred bucks from someone. If it is the [[dealer]] who is selling you the [[floating rate note]], then consider the final cashflows: you ''pay'' a fixed rate out of the income generated by your assets, the principal on the note you’ve bought cancels out against the principal of your loan and bingo: ''you have an interest rate swap''.


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 you’ve bought cancels out against your loan and ''you have an interest rate swap''.
====Leverage is a state of mind (or balance-sheet)====
====Leverage is a state of mind (or balance-sheet)====


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