Shape of Derivatives after financial crises - Ankit Singh - Bog

Derivatives have a fascinating, 10,000-year-old history. From the ages of Babylonian rulers to medieval times, all the way to present day electronic trading, various forms of derivatives have had a place in humanity's financial history. Based on an agreement around an underlying asset to exchange cash or other commodities within a specified time frame, derivatives are a way to invest and hedge assets without ever actually needing to possess the asset itself. Ancient History In Sumer in 8000 B.C., clay tokens were baked into a spherical sort of "envelope" and used as a promise to a counterparty to deliver a quantity of goods by a certain date. Based on the time frame imprinted into the envelope vessel and the tokens themselves, sellers promised to deliver the assets. This exchange essentially functioned as a sort of forward contract, which was settled once the seller delivered their goods by the date baked onto the token. The motivations for using swap contracts fall into two basic categories: commercial needs and comparative advantage. The normal business operations of some firms lead to certain types of interest rate or currency exposures that swaps can alleviate. For example, consider a bank, which pays a floating rate of interest on deposits (e.g. liabilities) and earns a fixed rate of interest on loans (e.g. assets). This mismatch between assets and liabilities can cause tremendous difficulties. The bank could use a fixed-pay swap (pay a fixed rate and receive a floating rate) to convert its fixed-rate assets into floating-rate assets, which would match up well with its floating-rate liabilities. Some companies have a comparative advantage in acquiring certain types of financing. However, this comparative advantage may not be for the type of financing desired. In this case, the company may acquire the financing for which it has a comparative advantage, then use a swap to convert it to the desired type of financing. For example, consider a well-known U.S. firm that wants to expand its operations into Europe, where it is less known. It will likely receive more favorable financing terms in the U.S. By using a currency swap, the firm ends up with the euros it needs to fund its expansion. Exotics CMS SWAP CMS swap is a kind of second order swap where you swap a rate of your choice against the above mentioned '10 year swap rate'. Every once in a while the rate is changed by referencing whatever Reuters says on that date the '10 year swap rate' is. Because it is always the 10 year rate that is referenced, it is called a constant maturity (in this case 10 year maturity) swap. Your payments however vary depending on developments in the market for ordinary swaps. A constant maturity swap (CMS) rate for a given tenor is referenced as a point on the Swap curve. A swap curve itself is a term structure wherein every point on the curve is the effective par swap rate for that tenor. This is analogous to a 3m LIBOR curve represents 3m forward rates for a given tenor. A swap rate can be considered as a weighted-average of forward rates. e.g. a two year par swap rate would be the fixed rate that makes a swap on (assume) LIBOR have NPV zero at inception. Usually, a LIBOR curve (or more generically a forward curve) would be bootstrapped using swap rates in the market (usually from 2y on-wards). For almost all derivatives you mentioned (best of my knowledge) you can liken them to their LIBOR counterpart where the reference curve is the par swap curve (effective swap rates per tenor) in lieu of the 3m LIBOR curve. e.g. a CMS swap's floating leg will (on fixing day) not refer the 3m LIBOR but the swap rate for the tenor instead. Moreover, one could also have the other leg floating and refer to LIBOR underlying curve.