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Template:M intro isda a swap as a loan: Difference between revisions
→Fixed/floating swaps
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{{drop|[[a swap as a loan|D]]|uring a typically}} [[The bilaterality, or not, of the ISDA|turgid disquisition]] about the “bilaterality” of the {{isdama}}, JC remarked that, despite ''looking like'' bilateral, even-stevens, un-[[loansome]] things, in fact swaps are ''implied financing arrangements''. | {{drop|[[a swap as a loan|D]]|uring a typically}} [[The bilaterality, or not, of the ISDA|turgid disquisition]] about the “bilaterality” of the {{isdama}}, JC remarked that, despite ''looking like'' bilateral, even-stevens, un-[[loansome]] things, in fact swaps are ''implied financing arrangements''. Hotly justifying this stance side-tracked the original article, so JC “[[Let’s take it offline|took things offline]]” and started a whole new article on the topic. Here it is. | ||
Hotly justifying this stance | |||
To recap the background to that post: | To recap the background to that post: | ||
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Aren’t “''normal''” swaps truly bilateral? How about a good old fashioned [[interest rate swap]]? Surely ''paying'' a [[fixed rate]], and ''receiving'' a [[floating rate]], has none of these same characteristics of borrowership about it? | Aren’t “''normal''” swaps truly bilateral? How about a good old fashioned [[interest rate swap]]? Surely ''paying'' a [[fixed rate]], and ''receiving'' a [[floating rate]], has none of these same characteristics of borrowership about it? | ||
The first | The first ting to say here is that in the real universe of actual, non-[[derivative]] instruments, interest rate cashflows ''do not exist independently of an investment in principal''.<ref>This is just as true of [[dividend]]<nowiki/>s on equities, of course.</ref> This is because an interest rate is, by definition, the ''income'' on a capital investment. | ||
Oh, sure, you can detach and 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 must buy it, cut it up and sell the stripped bond principal back into the market. Once you’ve done that, you have your disembodied interest cashflow, all right — but someone else has its dark inversion: this weird, mutilated, principal-only, [[Zero-coupon bond|zero-coupon]] instrument that trades at a heavy discount to its fully-limbed equivalent. It will exist, but unhappily: like Weird Barbie or one of those intercised children with no daemon in ''His Dark Materials''. Once you have sold the principal you might not be able to ''see'' it any more, ''but it is still there''. | |||
{{Quote|{{drop|“I|n the real world}} interest rates do not exist independently of principal investments. This is because an interest rate is, by definition, the income on a capital investment.”}} | |||
Repeat: in the real world, ''interest rate cashflows depend on income-generating assets''. It stands to reason. A rate without principal is like a shadow without a boy. | |||
Do swaps change all that? | |||
No: because at some point, swaps must be ''based in the reality from which they are derived''. This is not bitcoin, folks. | |||
====Derivatives as “engines of hypothesis”==== | ====Derivatives as “engines of hypothesis”==== | ||
{{quote| | {{quote| | ||
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FINANCE: (of a product) having a value ''deriving from'' an underlying variable asset. (''emphasis added'')}} | FINANCE: (of a product) having a value ''deriving from'' an underlying variable asset. (''emphasis added'')}} | ||
{{ | {{Drop|W|hen the [[Children of the Forest|Children]]}} [[Children of the Woods|of the Forest]] wrought their wristy magic on the [[First Men]] and the [[Single agreement|Way of the One Agreement]] passed into common understanding our leaden, earth-bound notions of “necessary principal” were swept away. Only then did the swap market take wing, upon the nuclear power of [[leverage]]. Income could flow, at last, unshackled of its leaden ''principal'' host, and was free to nudely frolic in ISDA’s glittering starlight. | ||
The “synthetic” world is an alternative, magical realm. Normal rules of [[space-time]] do not apply. There are amulets, magic instruments and imaginary tools with which even ordinary mortals can do impossible things. As we have seen, we can isolate income from [[principal]] and trade them hypothetically, as discrete instruments. | |||
But gravity is not banished; only ''postponed''. At some point, this fantasia must alight on planet Earth and engage with real-world instruments, ''because that is what it is all derived from''. Ultimately, somewhere, someone needs to construct each enchanting payoff from grubby, weighty, principal-laden corporate rights and obligations. Those rights and obligations are — on our mortal coil, must be — embedded in a scaly crust of principal. | |||
And ''that principal'' ''must be financed''. | |||
So if you want to earn [[floating rate]] on a notional of a hundred bucks in the real world, you pony up a hundred bucks. That 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 another investment, you must ''borrow'' from someone. | |||
If | If that someone is the [[dealer]] from whom you bought the [[floating rate note]], consider the final cashflows: you ''pay'' a fixed rate on your loan; you finance that from the income generated by your asset portfolio, the principal on the note you’ve bought cancels out against the principal of your loan and bingo: ''you have an interest rate swap''. | ||
====Leverage is a state of mind (or balance-sheet)==== | ====Leverage is a state of mind (or balance-sheet)==== | ||
{{smallcaps|One last way}} to look at this: an interest rate swap is a levered investment in a | {{smallcaps|One last way}} to look at this: an interest rate swap is a levered investment in a debt instrument. 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. | 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. | ||