The potentially grey and obscure world of complex financial instruments is often put aside for the purposes of maintaining both conversation and consciousness over dinner. The world of swaps was firmly placed in this category of protracted and almost irrelevant financial drudgery until one of the most influential speculators of all time labelled them as ‘financial weapons of mass destruction’. Warren Buffets remarks, back in 2003, pointed to a financial time bomb in the derivatives markets which may have the potential to seriously harm the financial world as we know it. The fact is, even if such derivatives were prohibited the market would almost naturally create a replacement. In other words, they have become essential and markets as we know them today have become dependent on them.
Starting with the notion of swaps, they belong to the derivative family of futures and options instruments. These all have a common factor that they are used by financial institutions to hedge against risk. Although there is nothing particularly sinister about this, finance has always been centred on the understanding and balance of risk and the buying of insurance to protect against this, the time bomb effect occurs when these means of risk protection become investment vehicles in their own right. The fact is that derivative contracts do not require an exchange of money reflecting the value of the contract. Many are purchased on margin and the only other exchange is the difference between the swapped contracts.
An example of how these weapons of mass destruction work is most straightforwardly explained using interest rate swaps as an example. These are often used to balance liabilities and assets which are, for whatever reasons, mismatched and therefore seen as potentially risky. The idea of a swap creates a market where two participants want to exchange an aspect of their current situation to reduce their risk and exposure. If company A is earning an income which pays a floating interest rate but has taken out a loan to buy its factory on a fixed interest repayments then it may consider its assets and liabilities mismatched. Potentially, there is a risk that its income will not be sufficient to pay for the interest on its loan repayments and the owners will start to look for a way to match both interest payments as either floating or fixed.
Company B on the other hand has a converse situation. It has a factory paid for by a loan which is subject to a floating interest rate whilst its income earns a fixed rate. If interest rates increased dramatically this company would be at risk of paying large quantities of interest to finance its loan whilst earning relatively very low levels on its fixed rate income interest. The risk here encourages the two mismatched companies to create a swap contract. They each have something that the other wants in the form of interest rate repayments. A notional value of the contract is agreed at, for example, $100 million and both companies agree on who will have the floating and who will have the fixed exchange rates to pay. Despite the size of the contract, the only money that is guaranteed to change hands is the difference between the fixed and flexible rates.
Clearly, one of the example companies may be better off paying 3% on a fixed rate whilst the other is paying 4% on the floating rates and the swap then requires the company benefitting from this to pay the difference as a percentage of the notional value. In this case there would be a 1% difference on a $100 million contract and thus $1 million to be paid to the company that has the higher floating rate. As Warren Buffet warned, the incredibly high value of many swap contracts does not reflect the reality of money exchanging hands. He has also compared the rigid nature of the contracts, which become derivatives in their own right, to hell…easy to enter and almost impossible to leave.