The Anatomy of a Swap

Bankers should not underestimate the importance of swaps.

"Not understanding derivatives is like not understanding computers. It's a whole dimension of risk management," said Peter Bennett, a managing director at J.P. Morgan & Co. and a veteran swap trader. Swaps are the largest component of the derivatives universe.

But like computers, swaps defy easy description. There are many variations, but in the simplest version of a plain-vanilla interest rate swap three things ordinarily happen: One party converts fixed rate to floating, a counterparty converts floating to fixed, and the swap dealer, usually a bank, makes money by capturing the spread between the rate it receives from one party and the rate it pays the other. Only interest payments change hands, never principal.

How One Issuer Might Hedge

Suppose an issuer sells long-term notes - whose total value is the swap's notional principal amount - with a fixed coupon, but expects interest rates to fall. It arranges to receive a fixed stream equal to its interest payments in exchange for making a floating payment tied to U.S. Treasury rates or to the London interbank offered rate (Libor).

In a separate swap agreement, the dealer arranges with a second counterparty to make floating-rate payments, in exchange for receiving fixed payments equal to the issuer's interest payments. Individual swaps seldom offset each other exactly.

The dealer agrees to accept floating-rate payments from the issuer at, say, 45 basis points over the benchmark, but payments to the counterparty are pegged at, say, at a 40-basis-point differential.

Returns on Equity Are High

The payoff for the dealer is a surprisingly high return on equity. A 5-basis-point spread on a deal with a notional value of $100 million means $50,000 in fees a year. That's small potatoes in comparison with the notional value. But measured against the actual amount of bank capital at risk, the return is far more impressive.

In this example, the dealer's credit exposure would be just a small portion of its payments, say, $2 million. And the capital allocated to that exposure would be even less - probably no more than 5% or $100,000. In effect, then, the $50,000 earnings represent a 50% return on equity.

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