Understanding OTC Derivatives Market

This assignment delves into the intricacies of Over-the-Counter (OTC) derivatives markets. It examines the influence of regulatory changes on non-financial entities involved in these markets. The document also explores the complexities of OTC derivatives, their applications in hedging, and the impact of central clearing arrangements. Furthermore, it discusses the economic effects of financial derivatives on corporate tax avoidance and analyzes recent dislocations in fixed income derivatives markets.

Running head: FINANCE
Finance
Name of the Student:
Name of the University:
Author Note:

2FINANCE
Table of Contents
Introduction......................................................................................................................................3
Swap derivative instruments............................................................................................................3
Types of swaps derivative instruments............................................................................................3
Importance of swaps derivative instruments...................................................................................6
Typical users....................................................................................................................................6
Usage as a risk management tool.....................................................................................................7
Pricing..............................................................................................................................................8
Effects of guidelines and Disclosure necessities of the instruments as required by the Securities
Exchange Commission....................................................................................................................8
Applying financial engineering to swap derivative instrument and other securities.......................9
Conclusion.....................................................................................................................................11
Reference List................................................................................................................................12

3FINANCE
Introduction
This study deals with discussion of derivative instruments named as forwards, futures,
swaps and options (Weber, 2016). All these derivative instruments work as risk management
instruments where these instruments plays an essential part in managing risk for international
companies as well as portfolio supervisors and recognized depositors. Using these derivative
instruments provide wide range of opportunities to the speculators in and across the world
(Bingham & Kiesel, 2013). The current segment identifies one derivative instrument (swap) for
discussion purpose. There are different types of swap derivative instruments that are commonly
used by the speculators and these are interest rate swaps and currency swaps that are traded over
the counters between fiscal organizations. In addition, these agreements are not traded on
exchanges. Furthermore, retail investors never trade in swaps (Sundaresan & Sushko, 2015). The
current segment proper explains the working of swap derivative instruments in the most efficient
way.
Swap derivative instruments
A swap is one of the derivative contracts that are made between two parties for
exchanging of cash flows in the future (Rahman et al., 2015).
Types of swaps derivative instruments
There are even other types of swaps that are mentioned below with proper justification:
Basis rate swap
Bond swap
Commodity swap

4FINANCE
Credit Default swap
Volatility swap
Interest rate swap
Currency swap
Forex swap
Interest rate swaps- Interest rate swaps is one of the type of swaps derivative instrument that are
essentially exchange of interest payments between two counter parties. There are three kinds of
interest rate swaps that include floating for fixed, fixed for floating and floating for floating. In
this swap, there is no exchange of principal and only coupon movements (Popova & Simkins,
2015).
For instance:
Fixed rate Floating rate
Company A 11% LIBOR+1%
Company B 10% LIBOR+0.5%

5FINANCE
Interest rate swaps can be used at the time of hedging or speculative activities.
Forex Swaps- Forex swap is one of the type of swap derivative instrument that is an arrangement
for interchange of currencies now at the dominant spot rate as well as exchanging the currencies
back in the future at the prevailing forward rate. There are two types of Forex swaps such as:
Current to Forward and Forward to Forward (Kidwell et al., 2016).
Currency Swap- Currency swap is related to interest rate swaps but interest payments are in
various cash (Rahman et al., 2015). In this case, the principal amount also changes at the time of
swap as well as maturity. Furthermore, all cash flows get related with the loan that are paid that
include preliminary receipts or imbursement of loaned principal, payment or receipt of interest in
the same money on that loan an eventual return or recover of the major at the end of the loan.
Using currency swaps avoid changes in exchange rates as well as exploiting inefficiencies
especially in international debt markets (Hirsa & Neftci, 2013).

6FINANCE
Importance of swaps derivative instruments
Swaps derivative instruments assist company’s hedge alongside interest rate contact by
reducing insecurity of future cash flows (Rahman et al., 2015). In addition, swapping help
companies for revising their obligation circumstances for taking benefit of present or predictable
upcoming market circumstances. Both currency as well as interest swaps are treated as monetary
tools for lowering the amount needed to service a debt. Currency and interest rate swaps guides
companies for taking benefit of the worldwide markets in an effective way by bringing organized
two parties that already have an benefit in various markets. There are some of the risks
connected with the opportunity where new party fails to meet the current responsibilities and the
paybacks are received by the company at the time of participating in a swap that outweighs the
costs (Gregory, 2014).
Typical users
Swaps derivative instruments are used by Corporations where they use swaps to a
number of various activities in value to a currency or detailed types of cash flows (Rahman et al.,
2015). These particular derivative instruments allow Business Corporation to value from
dealings that would not be likely in a appropriate or lucrative way. Swaps is one of the derivative
instruments that provide Corporations and chance to change the performance of their possessions
without really swapping possession of those resources and exceptionally prevalent as a technique
for managing risk as well as revenue generation. This derivative instrument are generally done
through a swap broker where the business deals in swaps as well as makes money off the bid-ask
spread between the bid price and ask price on these interactions. Spread is the variance between
the bid prices and ask price (Duffie & Stein, 2015).

7FINANCE
Usage as a risk management tool
Swaps derivative instruments are used for managing risk in wide variety of ways. Firstly,
individual can use swaps for ensuring satisfactory cash flows either through timing or through
the types of assets that is being exchanged. Timing with the coupon on bonds and assets being
swapped as with foreign altercation swaps that enhances a business establishment has the right
type of money. Therefore, the strict nature of the risk need to be achieved as it be contingent
upon the type of swap being used (Donohoe, 2015).
The simplest way to look at how businesses can use swaps for managing risks after
following simple example by using interest-rate swaps (Duffie & Stein, 2015).
Company A owns $1000000 in fixed rate bonds where the earnings is kept at 5% on annual basis
that is $50,000 in cash flow every year
Company A is of the opinion that interest rates increases at 10% that yields $1000000 annual
cash flows but exchanges all $1000000 for bonds that yields higher rates that itself is costly
affair (Duffie & Stein, 2015)
Company A visit to a swap broker and exchanges rights of the company to the future cash flows.
Company A as well as swap broker together continues to exchange these cash flows over the life
of the swap that ends on a date that is determined at the time of contract is signed ( Duffie &
Stein, 2015).
In this particular instance, it shows that swaps help Company A for managing risk by
making obtainable to Company A where the opportunity of altering its speculation portfolio

8FINANCE
without any cost and incredible to process for reorganizing ability possession (Cont & Kokholm,
2014).
Consequently, Company A makes an additional $50,000 per year in bond returns. Unlike
other investments, the business also losses money if interest rates for decreasing rather than
increase as Company A projected. It is the responsibility of the swap broker to help various
Business Corporations those benefits from swapping organized in an effective way. Therefore,
swap broker earns money by charging a fee (Choudhry et al., 2014).
Pricing
Currency swaps are priced or valued in same ways as interest rate swaps through use of
discounted cash flow analysis for obtaining zero coupon versions of the swap curves (Duffie &
Stein, 2015). In addition, the currency swaps in real transacts at inception with no net value.
Furthermore, over the life of the instrument, this swap derivative instrument can go in the money
or out of the money or it can stay at the money (Bryan & Rafferty, 2014).
Effects of guidelines and Disclosure necessities of the instruments as required by the
Securities Exchange Commission
Swaps regulation is one of the parts of the Dodd-Frank Act as well as have fallen under
the jurisdiction of different supervisory agencies like Commodity Futures Trading Commission
as well as Securities and Exchange Commission. There are other agencies that address swaps
execution facilities like Financial Services Authority as well as European Commission (Board,
2015).

9FINANCE
The General Disclosure Statement for Transactions that goes together with the Interest
Rate Derivatives Disclosures that contains significant information and disclosures on matters
relating to associated material risks, features, conflicts of interest as well as incentives (Duffie &
Stein, 2015). It is the responsibility of the swap dealer to either disclose or furnish at the time of
transacting activities. Individuals need to review carefully information as well as disclosures
before entering into any swap derivative instruments. There are terms used for interest rate swap
that enter in general way for determining statement. The standard forms of interest rate swaps
confirmation as it is ready available that include IRS Confirmation, IRS Confirmation with
embedded floor, Rate Cap Confirmation as well as Swaption Confirmation (Bingham & Kiesel,
2013).
Applying financial engineering to swap derivative instrument and other securities
The price of shedding risk can be treated as other risk that gives some upside potential of
the future transactions or in simple terms rate movement (Battiston et al., 2013). The allegations
explain some of the recent cases that leverage swaps that underscore the need for making such
understanding in a clear ways. Swap agreements can be termed as one of the prevalent types of
over the counter derivative contracts (Choudhry et al., 2014). The popularity of the market stems
comes from financial success where the market participants have experienced by making use of
swap agreements for managing risks in association with the commercial and financing
transactions. As far as financial engineering is concerned, it is important for the swap dealers to
identify as well as isolate with different risks in association with financial portfolios by
developing swap agreements that mainly address risks. There are numerous market contributors
that in actually had incurred considerable losses from trading swap agreements. Furthermore, the

10FINANCE
remarkable progression of the market gets along with the losses that took place on matters
relating to swap market that need regulations (Bingham & Kiesel, 2013).
Currently, it is noted that the swap dealings are not subject to any of the single
supervisory agenda. In addition, the swap transactions are mainly regulated to the extent to
which market contributors starts trading with these dealings that are controlled on regular basis
(Araujo & Leão, 2016). For instance, banks that are major OTC derivative dealers that are
overseen by federal bank controllers as it is subject to specific supervisory necessities where the
regulators are exposed
There are other major swap dealers where the insurance companies as well as securities
firms are subject to limited or federal oversight (Battiston et al., 2013). In addition, the outdated
method used for adaptable the financial markets that had been allocated by the supervisory
consultant of new monetary products that are based on whether the product falls within the
description of a safety or a futures
It is important to classify swap agreements as futures or securities as it differentiate in
both securities as well as futures (Choudhry et al., 2014). In addition, the OTC derivatives
market deals with pioneering market that projects financial instruments that are generally tailored
for meeting fiscal needs of counterparties. This type of instruments cannot be classified into
future or securities. It need subjecting to these instruments that exist from securities or
commodities laws that streamlines product developments as well as it prevent OTC derivative
dealers from competing efficiently with the foreign OTC derivatives that are subject to less
preventive instruction (Battiston et al., 2013).

11FINANCE
Conclusion
At the end of the study, it is concluded that swap derivative instruments had been
properly discussed in the study. The above analysis explains the types of swap derivative
instruments and how far it is important in real life. Swap derivative instruments is a risk
management tool that are used by Multinational Corporation, portfolio managers as well as
institutional investors. At the time of pursuing opportunities, it is important to cause revenue
through swaps derivative instruments where the procedure is no different. The swap is to take
benefits of differentials in the spot as well as anticipates future values in relation to swap
derivative instruments. It is not very much difficult to measure the value of swap. At the time of
estimating the future value, the calculations takes into account the time value of money as well
as probability of event occurrences that are treated for making the estimation of value of futures.
Therefore, the swap is nothing more than a grouping of spot rate interchange as well as future
exchange in a single contract.

12FINANCE
Reference List
Araujo, G. S., & Leão, S. (2016). OTC derivatives: Impacts of regulatory changes in the non-
financial sector. Journal of Financial Stability, 25, 132-149.
Battiston, S., Caldarelli, G., Georg, C. P., May, R., & Stiglitz, J. (2013). Complex
derivatives. Nature Physics, 9, 123-125.
Bingham, N. H., & Kiesel, R. (2013). Risk-neutral valuation: Pricing and hedging of financial
derivatives. Springer Science & Business Media.
Board, F. S. (2015). OTC derivatives market reforms. Ninth progress report on
implementation, 24.
Bryan, D., & Rafferty, M. (2014). Financial derivatives as social policy beyond
crisis. Sociology, 48(5), 887-903.
Choudhry, M., Moskovic, D., Wong, M., Baig, S., Liu, Z., Lizzio, M., & Voicu, A. (2014).
Credit Derivatives I: Instruments and Applications. Fixed Income Markets: Management,
Trading, Hedging, Second Edition, 375-419.
Cont, R., & Kokholm, T. (2014). Central clearing of OTC derivatives: bilateral vs multilateral
netting. Statistics & Risk Modeling, 31(1), 3-22.
Donohoe, M. P. (2015). The economic effects of financial derivatives on corporate tax
avoidance. Journal of Accounting and Economics, 59(1), 1-24.
Duffie, D., & Stein, J. C. (2015). Reforming LIBOR and other financial market benchmarks. The
Journal of Economic Perspectives, 29(2), 191-212.

13FINANCE
Gregory, J. (2014). The Future Impact on Financial Markets.Central Counterparties: Mandatory
Clearing and Bilateral Margin Requirements for OTC Derivatives, 283-285.
Hirsa, A., & Neftci, S. N. (2013). An introduction to the mathematics of financial derivatives.
Academic Press.
Kidwell, D. S., Blackwell, D. W., Sias, R. W., & Whidbee, D. A. (2016). Financial institutions,
markets, and money. John Wiley & Sons.
Popova, I., & Simkins, B. (2015). OTC vs. Exchange Traded Derivatives and Their Impact on
Hedging Effectiveness and Corporate Capital Requirements. Journal of Applied
Corporate Finance, 27(1), 63-70.
Rahman, A. A., Rahman, A. A., Md Ramli, R., & Ramli, R. M. (2015). Islamic Cross Currency
Swap (ICCS): hedging against currency fluctuations. Emerald Emerging Markets Case
Studies, 5(4), 1-12.
Sundaresan, S., & Sushko, V. (2015). Recent dislocations in fixed income derivatives
markets. BIS Quarterly Review, 8-9.
Weber, M. (2016). Central counterparties in the OTC derivatives market from the perspective of
the Legal Theory of Finance, financial market stability and the public good. European
Business Organization Law Review, 17(1-2), 71-103.