Financial Innovation Series

Over the past 50 years, the investment industry has seen stock market and real estate bubbles, interest rates approaching zero, the emergence of hedge funds and private equity companies, the globalization of financial markets, the proliferation of derivative securities, and the growth of securitized assets and structured financing. Mirroring these events has been the academic contributions to the investment discipline: the development of capital market theories, the derivation of option pricing models, and the explorations into efficient market theories. The financial events and the academic contributions together highlight what is truly an innovative financial industry. In this article, we examine one of the most significant industry innovations in the last forty years— the rise of the $37 trillion swap.

In 1981, Germany and Switzerland limited the World Bank from borrowing German marks and Swiss francs to finance its operations. IBM, on the other hand, had already borrowed large amounts of those currencies but needed U.S. dollars. To resolve this problem, Salomon Brothers arranged a swap in which IBM traded its borrowed francs and marks for the World Bank’s dollars. Many observers point to this World Bank and IBM currency swap as the agreement that propelled the tremendous growth that occurred in the currency swap markets over the last four decades. Today, it is common for corporations and financial institutions to exchange loans denominated in different currencies, creating a $21 trillion currency swap market.

A year after the World Bank and IBM swap, the Student Loan Marketing Association (Sallie Mae) issued a fixed-rate, intermediate-term bond through a private placement and swapped it for a floating-rate note issued by the ITT Corporation. This exchange of the floating-rate loan for the fixed-rate one represented the first interest rate swap. The swap provided ITT with fixed-rate funds at a rate below the rate they could obtain on a direct fixed-rate loan, and it provided Sallie Mae with cheaper intermediate-term, floating-rate funds – both parties, therefore, benefited from the swap. Today, there exists a $14.7 trillion interest rate swap market consisting of financial and non-financial corporations who annually conduct (as measured by contract value) swaps of fixed-rate loans for floating-rate loans. Financial institutions and corporations use the market to hedge their liabilities and assets more efficiently – transforming their floating-rate liabilities and assets into fixed-rate ones or vice versa and creating synthetic fixed or floating-rate liabilities and assets with better rates than the ones they can directly obtain.

Concomitant with the growth of interest rate and currency swaps there has been a number of innovations introduced in swaps contracts over the years. Today, there are several non-generic swaps used by financial and non-financial corporations to structure their liability and asset positions. Over the last decade, one of the most popular swaps has been the credit default swap. Introduced by JP Morgan in 1994, this swap allows companies to trade credit risk and by so doing change their debt and fixed-income assets credit risk exposure. During the 2008 financial crisis, credit default swaps on mortgage-backed securities were one of the contributing factors to the economic downturn.

Whether it is an exchange of currency-denominated loans, fixed and floating interest rate payments, or payments of insurance premiums for credit protection, a swap, by definition, is a legal arrangement between two parties to exchange specific payments. This article examines this $37 trillion swap market.

Interest Rate Swaps

The simplest type of interest rate swap is the plain vanilla or generic swap. In this agreement, one party provides fixed-rate interest payments to another who provides floating-rate payments. The parties to the agreement are referred to as counterparties. The party who pays fixed interest and receives floating is the fixed-rate payer; the other party (who pays floating and receives fixed) is the floating-rate payer. On a generic swap, principal payments are not exchanged. As a result, the interest payments are based on a notional principal (NP).

The interest rate paid by the fixed payer often is specified in terms of the yield to maturity (YTM) on a T-note plus basis points; the rate paid by the floating payer on a generic swap is the London Interbank Offer Rate, LIBOR (a short-term rate often used to set rates on floating rate debt). Swap payments on a generic swap are semiannual and the original maturities typically range from three to 10 years. In the swap contract, the effective date is the date when interest begins to accrue; the settlement or payment date is when interest payments are made (interest is paid in arrears six months after the effective date). On the payment date, only the interest differential between the counterparties is paid. Thus, if a fixed-rate payer owes $3 million and a floating-rate payer owes $2.5 million, then only a $0.5 million payment by the fixed payer to the floating payer is made.

To illustrate, consider a 3.5% fixed rate for floating rate swap with a notional principal of $10 million, maturity of three years, starting on 3/15/Y1, and maturing on 3/15/Y4. In this swap agreement, the fixed-rate payer agrees to pay the current yield on a three-year T-note of 3.5% and the floating-rate payer agrees to pay the 6‑month LIBOR as determined on the effective dates with no basis points, with payments made six months later. The semiannual interest rates are determined by dividing the annual rates (LIBOR and 3.5%) by two. Exhibit A shows the interest payments on each settlement/payment date based on assumed LIBORs on the effective dates. In examining the table, several points should be noted. First, the payments are determined by the LIBOR prevailing six months prior to the payment date; thus, payers on swaps would know their obligations in advance of the payment date. Second, when the LIBOR is below the fixed 3.5% rate, the fixed-rate payer pays the interest differential to the floating-rate payer; when it is above 3.5%, the fixed-rate payer receives the interest differential from the floating-rate payer. The net interest received by the fixed-rate payer is shown in Column 5 of the table, and the net interest received by the floating-rate payer is shown in Column 6.

Synthetic Positions

One of the important uses of interest rate swaps is in creating synthetic fixed-rate or floating-rate liabilities or changing a conventional fixed-rate loan (or floating-rate loan) to a floating-rate (fixed-rate) to minimize the borrower’s debt position’s exposure to interest rate changes. For example, a company with floating-rate debt that was expecting a higher interest rate could fix the rate on its debt by combining the company’s floating debt with a fixed-rate payer’s position on a swap, thereby creating a synthetic fixed-rate debt position.

Exhibit A: Interest Rate Swap

• 3.5%/LIBOR Swap with NP = $10 million: Columns 3-6

• Synthetic Fixed Rate Loan: Floating-Rate Loan set at LIBOR and Fixed-Payer Position on 3.5%/LIBOR Swap: Columns 7-9

• Synthetic Floating-Rate Loan: 3.50% Fixed-Rate Loan and Floating-Payer Position on 3.5%/LIBOR Swap: Columns 10-12

For example, suppose a corporation has a three-year $10 million floating-rate loan, with the rate set equal to the LIBOR on March 15th and September 15th each year for three years. Fearing that interest rates could increase in the future, suppose the company would like to convert its floating-rate debt to a three-year, $10 million fixed-rate loan starting on 3/15/Y1. Instead of borrowing $10 million from a bank at a fixed rate to refinance its floating-rate debt, the company alternatively could attain a fixed-rate loan by combining its floating-rate loan with a fixed-rate payer's position on the swap:

As shown in Exhibit A (Columns7-9), if the floating-rate loan is combined with a swap, any change in the LIBOR would be offset by an opposite change in the net receipts on the swap position. In this example, the company would end up paying a constant $175,000 every sixth month, which equates to an annualized borrowing rate of 3.5%.

Alternatively, a company with fixed-rate debt that is expecting rates to decline could convert the fixed-rate debt to floating-rate debt with a floating-rate payer’s position on a swap:

An example of a synthetic floating-rate loan is shown in Exhibit A (columns 10-12). The synthetic loan is formed with a 3.5% fixed-rate loan (semiannual payments) and the floating-rate payer's position on the 3.5% for LIBOR swap.

Medium-Term Notes and Swaps

A medium-term note (MTN) is a debt instrument sold on a continuing basis to investors who are allowed to choose from a group of bonds from the same corporation, but with different maturities—a serial corporate bond issue. MTNs were first introduced in the 1970s when General Motors Acceptance Corporation (GMAC) sold such instruments to finance its automobile loans. The market for MTNs took off in the early 1980s when Merrill Lynch began acting as an agent in issuing MTNs and also as a dealer by making a secondary market for the notes. Since then, the MTN market has grown significantly. They are often sold through investment banking firms who act as agents. The agents post the maturity range for the possible notes in the program and their offering rates. Today, MTNs are issued not only by corporations, but also by bank holding companies, government agencies, supranational institutions, and sovereign countries. MTNs vary in terms of their features. Some, for example, are offered with fixed rates, where others pay a floating rate; some are unsecured whereas others are secured (e.g., equipment-trust MTN).

It is common for MTN to be offered with derivatives (swaps, caps, floors, futures, and forward contracts). MTNs that are combined with other instruments are referred to as structured notes. The most common derivatives used are interest rate, currency and credit default swaps. A corporation, for example, might issue MTNs with a fixed rate that its investment bank sells to a financial institution along with a floating-rate payer position on a swap, making it an effective floating-rate debt.

Asset Swaps

In the early days of the swap market, swaps were primarily used as a liability management tool. In the late 1980s, investors began to use swaps to try to increase the yield on their investments or to reduce their interest rate risk exposure. A swap used with an asset is referred to as an asset-based interest rate swap or simply an asset swap. For financial corporations, speculative positions often take the form of the company changing the exposure of its balance sheet to interest rate changes. For example, suppose a fixed-income bond fund with an expectation of a lower interest rate could change its portfolio’s interest rate exposure by taking a floating-rate payer’s position on a swap. If they did this and rates were to decrease, then not only would the value of the fund’s bond portfolio increase, but the fund would also profit from the swaps. On the other hand, if rates were to increase, then the company would see decreases in the value of its bond portfolio, as well as losses from its swap positions. By adding swaps, though, the fund has effectively increased its interest rate exposure. If the fund wanted to reduce its bond portfolio’s interest rate exposure based on an expectation of higher interest rates it could take a fixed-rate payer’s position on a swap. If rates were to later increase, then the decline in the value of the company’s bond portfolio would be cushioned by the gains realized from the fixed-payer’s position on the swap.

Swap Banks

The core of the swap market consists of commercial and investment banks who act as brokers and dealers. These dealers and brokers are collectively referred to as swap banks. As brokers, swap banks match parties with opposite needs. Many of the first interest rate swaps were customized brokered deals between counterparties, with the parties often negotiating and transacting directly between themselves. With a brokered swap, the swap bank’s role in the contract is to bring the parties together and provide information. One of the problems with a brokered swap is that it requires each party to have knowledge of the other party’s risk profile. This problem led to swap banks taking more positions as dealers instead of as brokers. With dealer swaps, the swap dealer makes commitments to enter a swap as a counterparty before the other party has been located.

In acting as dealers, swap banks often initiate the swap by hedging their position with a synthetic swap position formed by borrowing/shorting (investing in) a T-note and investing (borrowing/shorting) in a floating-rate bond. For example, a swap bank offering a corporation a $10 million floating-rate position on a three-year 3.5%/LIBOR swap would assume the fixed payer’s position. If three-year T-notes were trading to yield 3.5%, the swap bank would hedge its swap obligation to pay a 3.5% fixed rate and receive LIBOR by selling $10 million worth of three-year, 3.5% fixed-rate T-notes at par that it is either holding or it borrows, and then use the proceeds to purchase of $10 million worth of three-year floating-rate notes (FRNs) with the rate reset every six months at the LIBOR. The sale of the 3.5% fixed-rate bonds and the purchase of FRN would yield a floating-rate cash flow and a fixed-rate obligation, which would offset the swap.

Over time, the swap bank would close its bond positions when it took a fixed-rate payer position on a similar swap. A $30 million fixed-for-floating swap between a swap dealer and one party might be matched by the swap bank with two $15 million floating-for-fixed swaps or with one $5 million swap and a $5 million floating-rate debt and $5 million fixed-rate investment. In practice, swap banks are prepared to enter a swap agreement without an opposite counterparty. This practice is referred to as warehousing. In warehousing, swap banks will hedge their swap positions with opposite positions in T-notes and FRNs or Eurodollar futures contracts. This type of portfolio management by swap banks is referred to as running a dynamic book.

By offering swaps and being in a position to create synthetic swaps, swap banks are able to close existing swap positions prior to maturity. As a result, swap positions are often closed by selling the swap to a swap dealer. The swap bank either pays or receives an upfront fee to or from the existing counterparty in exchange for assuming their position. In assuming the swap, the swap bank will hedge the swap position by taking an opposite position in a currency swap or by hedging the assumed position for the remainder of the maturity period with T-note/FRN positions or with a future or forward contract. For example, a swap bank, in assuming a fixed-rate payer position, could take a floating-rate payer's position in a new swap contract, go long in an appropriate futures contract, or take opposite positions in current T-notes and FRNs.

Swap Valuation and Closing Swap

Suppose in the illustrative swap example shown in Exhibit A, there is a decline in interest rates one year after the initiation of the swap, causing the fixed-rate payer on the 3.5% for LIBOR swap to want to close his position with a swap bank. To close, the swap bank would assume the fixed payer’s 3.5%/LIBOR swap and then hedge the assumed position by entering a new two-year swap. If the current two-year swap is a 3%/LIBOR swap, then the bank would take the floating payer position on the swap. As shown in Exhibit B, the swap bank’s two positions would result in a fixed payment of $25,000 semiannually for two years ((.005/2) $10,000,000).

Exhibit B

In acquiring a fixed position at 3.5% and hedging it with a floating position on a 3% fixed for LIBOR swap, the swap dealer would therefore lose $25,000 semiannually for two years on the two swap positions given a $10 million notional principal. Thus, the price the swap bank would charge the fixed payer for buying his swap would be at least equal to the present value of $25,000 for the next four semiannual periods. Given an annual discount rate of 3%, the swap bank would charge the fixed payer a minimum of $96,360 for buying his swap. In contrast, if rates had increased, the fixed payer would be able to sell the swap to a dealer at a premium. For example, if the fixed rate on a new swap were 4%, a swap dealer would realize a semiannual return of $25,000 for the next two years by buying the 3.5%/LIBOR swap and hedging it with a floating position on a two-year, 4%/LIBOR swap. Given a 4% discount rate, the dealer would pay the fixed payer a maximum of $95,193 for his 3.5%/LIBOR swap.

Just the opposite values apply to the floating position. If the fixed rate on new two-year par value swaps were at 3%, then a swap bank who assumed a floating position on a 3.5%/LIBOR swap and then hedged it with a fixed position on a current two-year 3%/LIBOR swap would gain $25,000 semiannually over the next two years. As a result, the swap bank would be willing to pay $96,360 for the floating position. Thus, the floating position on the 3.5% swap would have a value of $96,360.

Non-Generic Swaps and Swap Derivatives

Today, there are a number of non-generic interest rate swaps used by financial and non-financial corporations to manage their varied asset and liability positions. Non-generic swaps usually differ from generic swaps in terms of their rates, principal, or effective dates. For example, instead of defining swaps in terms of the LIBOR, some swaps use the T-bill rate, prime lending rate, or the Federal Reserve’s Commercial Paper Rate Index with different maturities.

In addition to generic swaps, there is also an extensive market for swap derivatives—forward swaps and swaptions. A forward swap is an agreement to enter into a swap that starts at a future date at an interest rate agreed upon today. A swaption is an option on a swap. Specifically, a payer swaption gives the holder the right to enter a particular swap as the fixed-rate payer, whereas a receiver swaption gives the holder the right to enter a particular swap agreement as the fixed-rate receiver (and floating-rate payer). Forward swaps and swaptions are used for speculating on interest rates, hedging debt and asset positions against market risk, and managing a balance sheet’s exposure to interest rate changes.

Currency Swaps

A currency swap involves an exchange of principal and interest of a loan in one currency for the interest and principal in another. Many currency swaps are the result of corporations exploiting a comparative advantage resulting from different rates in different currencies for different borrowers. The existence of a comparative advantage creates a currency swap market in which swap banks can arrange swaps that provide each borrower with rates better than the ones they can directly obtain. For example, suppose the U.S. dollar/British pound exchange rate is $1.50/£ (or £0.66667/$), and there is a U.S. Company that wants to borrow 100 million British pounds for three years and a British company that wants to borrow $150 million for three years. Suppose further that the U.S. Company can either obtain a three-year $150 million loan at 5% and then convert the dollars to £100 million at the £0.66667/$ exchange rate, or it can directly obtain a three-year, 3.25% sterling-denominated loan. In contrast, suppose the British Company can either borrow £100 million at 3.5% for three years and then convert it to $150 million at the $1.50/£ exchange rate, or directly obtain a three-year $150 million loan at 6%.

Loan Rates for U.S. and British Companies in Dollars and Pounds

With these rates, the U.S. Company has a comparative advantage in the U.S. dollar market. It pays 1% less than the British Company in the U.S. dollar market, compared to only 0.25% less in the British pound market. On the other hand, the British Company has a comparative advantage (or smaller comparative disadvantage) in the British market. It pays 0.25% more than the U.S. Company in the British pound market, compared to 1% more in the U.S. dollar market. When such a comparative advantage exists, a swap bank is in a position to arrange a swap to benefit one or both companies. For example, a swap bank might set up a swap arrangement in which: (1) the U.S. Company borrows $150 million at 5% and agrees to swap it for £100M loan at 3%; (2) the British Company borrows £100M at 3.5% and agrees to swap it for a $100 million loan at 5.75%. Exhibit C shows the cash flows of interests for the agreement. In this swap arrangement, the U.S. company benefits by paying 0.25% less than it could obtain by borrowing British pounds directly in the British pound market, and the British Company gains by paying 0.25% less than it could obtain directly from the U.S. dollar market.

The swap bank, in turn, receives $8.625 million each year from the British Company, while only having to pay $7.5 million to the U.S. Company, for a net dollar receipt of $1.125 million. In contrast, the swap bank receives only £3 million from the U.S. Company, while having to pay £3.5 million to the British Company, for a net sterling payment of £0.5 million. The swap bank has a position equivalent to a series of long currency forward contracts in which it agrees to buy £0.5 million for $1.125 million each year. The swap bank's implied forward rate on each of these contracts is $2.25/£ (= $1.125m/£0.5m). The swap bank will, in turn, hedge its position by entering forward contracts to buy £0.5m each year for the next three years, and it will profit provided the forward rates are less than $2.25/£ (it wouldn’t offer the swap unless it could hedge its positions at forward rates less than$2.25/£). For example, if the swap bank entered forward agreements to buy £0.5m one year forward at $1.529126/£, £0.5m two years forward at $1.558818/£, and £0.5m three years forward at $1.589086/£, it would realize a total profit from the deal of $1,036,485:

Swap Bank Position

In summary, the presence of comparative advantage creates a currency swap market in which swap banks look at the borrowing rates offered in different currencies to different borrowers and at the forward exchange rates and money market rates that they can obtain for hedging. Based on these different rates, swap banks will arrange swaps that provide borrowers with rates better than the ones they can directly obtain, as well as a profit for them that will compensate them for facilitating the deal and assuming the credit risk of each counterparty.

Changing Earnings Exposure to Exchange Rate Changes using Swaps

In addition to comparative advantage, currency swaps are often used by investment bankers in the MTN market, as well as other debt markets. For example, an investment bank underwriting a U.S. corporation’s dollar-denominated MTN could sell the MTN to a British financial institution along with a British pound/USD currency swap, making it a British pound-denominated MTN for the British financial institution.

Another important use of currency swaps is reducing a multinational company’s earnings or balance sheet exposure to exchange-rate fluctuations. For example, a U.S.-owned company that operates an oil refinery in the United Kingdom and sells its refined oil in British pounds to its British market would have its revenue exposed to exchange-rate changes. However, if the U.S. owned-company also operates in Great Britain it would also have operating costs subject to exchange rate changes. Thus, the company would have a British pound cost to partially offset its British pound revenue to exchange rate changes, reducing its earnings exposure to exchange rate changes. This is known as an operational hedge. An operational hedge is considered a natural hedge—hedging without derivatives. However, if the British pound operating cost is relatively small, its operational hedge is very small as well. One of the firm’s expenses, however, is the interest payment on its debt. If the U.S.-owned company’s debt were in British pounds, then the company would have an interest payment expense in British pounds. Such an expense would serve to reduce the U.S. company’s earnings exposure to changes in the exchange rate. If the company’s debt, though, is denominated in dollar, it could use the currency swap market to swap its current U.S. dollar-denominated debt for British pound debt in the swap market. If the $/£ exchange rate decreased, the U.S. company’s reduction in revenue in dollars would be partially offset by the lower dollar cost to pay the interest on the British pound debt. By swapping its dollar-denominated for British pound-denominated debt, the company has improved its operational hedge, stabilizing its earnings exposure to exchange rate changes.

Credit Default Swaps

Historically, a bond portfolio manager with speculative-grade bonds or a financial institution with a portfolio of loans managed their portfolio’s exposure to credit risk by the selection and allocation of credits in their portfolio. With the credit default swap market, however, a bond manager or lender could alternatively change her credit risk by simply buying or selling swaps to change the credit risk profile on either an individual bond or loan or on a bond or loan portfolio.

In a standard credit default swap (CDS), one party buys protection against default by a particular company or economic entity from another party (seller). The company or entity is known as the reference entity, and a default is known as a credit event. The buyer of the CDS makes periodic payments or a premium to the seller until the end of the life of the CDS or until the credit event occurs. The payment is referred to as the CDS spread. If the credit event occurs, then the buyer has the right to sell the defaulted bond issued by the company for its par value (physical delivery). Alternatively, some contracts allow the buyer to receive a cash settlement based on the difference between the par value of the defaulted bond and the bond’s recovery value.

CDS are used primarily to manage the credit risk on debt positions. For example, a bond fund manager holding a 5-year BBB corporate bond yielding 5% could minimize the credit risk on the bond by buying a 5-year CDS on the bond. If the payments or spread on the CDS were equal to 2% of the bond’s principal, then the purchase of the CDS would have the effect of making the 5% BBB bond a lower credit risk bond yielding 3%. That is, if the bond does not default, then the bond fund manager will receive 3%: 5% from BBB bond minus the 2% spread paid on the CDS. If the bond defaults, then the bond manager would receive 3% from the bond and CDS up to the time of the default and then would receive the face value on the bond from the CDS, which the manager can reinvest for the remainder of the 5-year period. Thus, the CDS allows the manager to reduce the credit risk on the bond.

In contrast, suppose a manager holding a portfolio of 5-year U.S. Treasury notes yielding 3%, expected the economy to improve and therefore was willing to assume more credit risk in return for a higher return by buying BBB corporate bonds yielding 5%. As an alternative to selling his Treasuries and buying the corporate bonds, the manager could sell a CDS. If the manager were to sell a 5-year CDS on the above 5-year BBB bond to a swap bank for the 2% spread, then the manager would be adding 2% to the 3% yield on his Treasuries to obtain an effective yield of 5%. Thus, with the CDS, the manager would be able to obtain an expected yield equivalent to the BBB bond yield and with the swap position would assume the same credit risk associated with a BBB bond.

In the primary market, CDS are provided by investment bankers on MTNs and other debt issues to change the credit risk exposure of the issuer’s bonds to the investors. For example, a corporation with a lower quality rating might issue MTNs that its investment bank sells to a financial institution along with a credit default swap position to lower the credit risk to the institution.

Collateralized Debt Obligations

Arbitrage strategies of selling a higher (lower) quality bond, buying (selling) CDS, and purchasing lower (higher) quality bonds was the basis of many synthetic collateralized debt obligation (CDO) structures formed by many investment banking firms prior to the 2008 financial crisis. That is, when the CDS spread were underpriced, an investment bank (referred to as a sponsor) would issue investment-grade CDOs and then use the proceeds to buy speculative-grade bonds and CDS; when CDO spreads were overpriced, the CDO sponsors would issue lower-quality CDOs, sell CDS, and purchase investment-grade bonds.

Before the financial crisis of 2008, the issuance of collateralized debt obligations, along with the issuance of MTN and other debt issues structured with CDS, contributed to the significant growth of the CDS market. During the financial crisis of 2008, however, the CDS market was hit hard. Just prior to the crisis, Lehman Brothers, for example, owed $600 billion in debt, out of which $400 billion was covered by CDS. The bank’s insurer, American Insurance Group, lacked sufficient funds to clear the debt, and the Federal Reserve was forced to intervene to bail them out. One of the major problems with the market was the absence of a legal framework to regulate swaps. The Dodd-Frank Act of 2009 was subsequently passed by Congress to regulate the credit default swap market. The act phased out the riskiest swaps, prohibited banks from using customer deposits to invest in swaps and other derivatives, and authorized the Commodity Futures Trading Commission set up of a clearinghouse to trade and price swaps.

Conclusion

Since the 1970s, the global economy has experienced relatively sharp swings in stock prices, interest rates, and exchange rates. This volatility, in turn, has increased the exposure of many debt, equity, and currency positions to interest rate, credit, and exchange rate risk. Faced with these risks, many institutional investors, corporations, borrowers, money managers, intermediaries, and portfolio managers have increased their use of futures, options, and swap contracts. Like futures and options, swaps provide investors and borrowers with a tool for hedging asset and liability positions and improving the returns received on fixed-income investments or the rates they pay on debt position. Today, swaps have become a basic financial engineering tool for corporate treasurers, fixed-income portfolio managers, money managers, investment bankers, and security dealers.

Exhibit D: Non-Generic Swaps

• Equity Swap: Swap in which one party pays the return on a stock index and the other pays a fixed or floating rate.

• Basis Swap: Swaps in which both rates are floating; each party exchanges different floating payments: One party might exchange payments based on LIBOR and the other based on the Federal Reserve Commercial Paper Index.

• Total Return Swap: Returns from one asset are swapped for the returns on another asset.

• Binary CDS: A binary CDS is identical to the generic CDS except that the payoff in the case of a default is a specified dollar amount.

• Basket CDS: In a basket credit default swap, there is a group of reference entities or credits instead of one and there is usually a specified payoff whenever one of the reference entities defaults.

• CDS Forward Contracts: A CDS forward contract is a contract to take a buyer’s position or a seller’s position on a particular CDS at a specified spread at some future date. CDS forward contract provide a tool for locking in the credit spread on future credit position.

• CDS Option Contracts: A CDS option is an option to buy or sell a particular CDS at specified swap rate at a specified future time.

• Contingent CDS: A contingent CDS provides a payout that is contingent on two or more events occurring.

• Total Return Swaps: In a total return swap, there is an agreement to exchange the return on an asset (such a bond, bond portfolio, stock or stock portfolio) for some benchmark rate such as LIBOR plus basis points.

• Equity Swap: In an equity swap, one party agrees to pay the return on an equity index, such as the S&P 500, and the other party agrees to pay a floating rate (LIBOR) or fixed rate.

References