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Template:M intro isda a swap as a loan: Difference between revisions
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But, hang on: this is a bilateral arrangement, right, so isn’t the converse also true, of the dealer? Isn’t the dealer, in a sense, “borrowing” by paying the total return of the asset to get “exposure” to the floating rate in the same way? Is not a “short” swap position, for a dealer, exactly the same as a “long” swap position for a customer? | But, hang on: this is a bilateral arrangement, right, so isn’t the converse also true, of the dealer? Isn’t the dealer, in a sense, “borrowing” by paying the total return of the asset to get “exposure” to the floating rate in the same way? Is not a “short” swap position, for a dealer, exactly the same as a “long” swap position for a customer? | ||
No, because in providing these swap exposures to its customers, the dealer simultaneously [[Delta-hedging|delta-hedges]]. It does not | No, because in providing these swap exposures to its customers, the dealer simultaneously [[Delta-hedging|delta-hedges]]. It does not chang its own market position. The customer ''buys'' an exposure: that is, starts ''without'' and ends up ''with'' a “position”; the dealer manufactures and then ''sells'' an exposure: it starts ''without'' a position, takes an order, creates a position, transfers it to the customer and ends up where it started, ''without'' a position. | ||
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. | 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. | ||
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The first point to make here is that in the real universe of actual, non-[[derivative]] instruments, fixed or floating rate cashflows ''do not exist independently of principal investments''. (This is just as true of [[dividend]]<nowiki/>s on equities, of course). This is because a cashflow is necessarily ''income'' on a capital investment. | The first point to make here is that in the real universe of actual, non-[[derivative]] instruments, fixed or floating rate cashflows ''do not exist independently of principal investments''. (This is just as true of [[dividend]]<nowiki/>s on equities, of course). This is because a cashflow is necessarily ''income'' on a capital investment. | ||
Oh, sure, you could 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 back into the market. Once you’ve done that, you have your disembodied interest cashflow, all right — but you are left with this weird, mutilated, principal-only, [[Zero-coupon bond|zero-coupon]] instrument that you must sell into the market 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 it you might not be able to see the principal investment any more, ''but it is still there''. | Oh, sure, you could 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 back into the market. Once you’ve done that, you have your disembodied interest cashflow, all right — but you are left with this weird, mutilated, principal-only, [[Zero-coupon bond|zero-coupon]] instrument that you must sell into the market 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 it you might not be able to ''see'' the principal investment any more, ''but it is still there''. | ||
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. | ||
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”==== | ====Derivatives as “engines of hypothesis”==== | ||
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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. | 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. | ||
The | 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 do not apply. | ||
But gravity is not banished; only ''postponed''. At some point, our | 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. | ||
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 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''. | ||
====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 | {{smallcaps|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. | 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. | ||