Swap Essay

In the financial derivatives markets, a swap is an agreement between two parties (counterparties) to swap cash flows for a specified period. A swap is a risk management technique. Swaps are used for hedging (insuring) against adverse movements in interest rates and foreign exchange rates. They provide certainty about future interest payments or foreign exchange liabilities, either through fixing payments or matching variable cash in-flows with variable cash out-flows.

The advantages of swaps are that they are flexible in size and duration and can be tailored to the requirements of the parties. The duration advantage is important because the parties can arrange swaps for as long a period as they wish. Swaps are over-the-counter (OTC) instruments with counterparty (default) risk. The international swap markets have grown enormously since the late 1970s and deal in interest rates, currencies, and commodities. The vast bulk of business is in interest rate swaps. Participants include the counterparties and swap dealers and brokers, who act as intermediaries. Central banks also use swaps to obtain foreign exchange for short-term market intervention. The principal swaps are in interest rates and currencies.

An interest rate swap is based on the interest rates differential between two parties with a common currency. If one party enjoys better borrowing terms than another party, then it is possible for the first party to sell part of its advantage to the other so that both can pay lower rates than they would by borrowing independently. The differing interest rates reflect the differing credit ratings of the parties (the quality spread).

For the swap to work, one party will want to pay a fixed rate and the other a variable rate on a common principal amount of borrowing. For example, Party A may be able to borrow fixed-rate funds at 12 percent and variable (floating)-rate funds at 9 percent, while Party B may be able to borrow fixed-rate funds at 10 percent and variable-rate funds at 8 percent. By negotiation, the parties could agree that B will raise money at 10 percent fixed rate and A will raise the variable funds at 9 percent. They will pay each other’s interest commitments. If A also compensates B 1.5 percent, a situation will be produced where A is paying an effective fixed rate of 11.5 percent and B is paying an effective variable rate of 7.5 percent. Both parties are paying 0.5 percent less on their borrowing than they would by acting independently. The principal amount is not exchanged because each party raises the same amount in the same currency. Effectively, one party to an interest rate swap is selling some of its superior credit rating advantage to the other party to their mutual advantage.

The simplest currency swaps are where two parties agree to swap regular payments in each other’s currency for a specified period at a mutually agreed exchange rate. For example, an American company might want to invest in France and a French company in America. The American company would provide the French company with dollars and the French company would provide euros to the American company at the agreed exchange rate. Each would make periodic payments to the other to cover the interest payments on the funds each had raised. At the termination of the agreement, each would exchange principal payments at the agreed exchange rate, enabling both to settle their borrowings. This would be an entirely private arrangement divorced from the currency market itself. A more complex swap would be the fixed-for-floating currency swap involving both a fixed-for-variable interest element and a currency element. One party will pay a fixed rate of interest on borrowings in one currency while the other pays a variable rate on borrowings in another currency. In this form of swap, the principal is also exchanged at the end of the agreement period to meet the repayment to the respective creditors.

Swaps can be arranged directly between parties who know each other. However, on such a basis, the scope for swaps would be very restricted. Consequently, most swaps will be arranged through dealers and brokers who will bring parties together. Brokers will introduce parties to each other, while dealers will arrange the swap and, for a fee, assume counterparty (default) risk. This is the risk that one party will fail to meet its obligations to the other. A further development of the swap instrument is the swaption. This is an option on a swap at a future date on terms agreed now. The holder can choose to exercise the option or not. This represents a derivative instrument in a derivative.

Bibliography:

  1. Carol Alexander and Andreas Kaeck, “Regime Dependent Determinants of Credit Default Swap Spreads,” Journal of Banking and Finance (v.32/6, 2008);
  2. Wolfram Boenkost and Wolfgang M. Schmidt, Cross Currency Swap Valuation (HfB, 2004);
  3. W. Kolb, Financial Derivatives (Blackwell, 2000);
  4. Pilbeam, Finance and Financial Markets (Palgrave, 2005).

Sweden

Sweden, with approximately 9 million inhabitants, is characterized by its highly developed welfare state and an economic history and performance where exploitation of natural resources has been combined with refining such materials for export. Sweden is one of the world’s leading producers of iron ore, and also extracts copper, lead, zinc, and pyrite. Manufacturing activities include iron and steel-based products, machinery, precision equipment, and motor vehicles, and trade balance has in usual years been slightly positive in Sweden’s favor. Sweden joined the European Union (EU) in 1995.

Sweden was like most European countries, a late but rapidly industrializing country that was predominantly agrarian until the latter half of the 19th century, with exports dominated by basic agriculture, mining, and forestry products. From the mid-19th century onward, new types of machinery (e.g., for producing pulp and paper) allowed for refinement of such products, and engineering as an industry by itself subsequently developed in terms of both employment and export shares (3 percent in 1880, 10.5 percent in 1910–11, and 20 percent in 1950) reaching an international status in the 1950s surpassed only by the United States. But until the 1980s and early 1990s, the more fast-growth high-technology sectors were not dominant within the Swedish economy. In fact, the proportion of production in industries that are intensive in research and development (R&D) efforts declined during 1975–91.

As pointed out by C. Edquist and L. Hommen, the entry into the EU in 1995 was in part motivated by the insight that the domestic market did not provide a sufficient basis for the growth and the development of new technologies and industries, and there was subsequently a need for increased exposure to international demand. This strategy did not immediately result in a more diverse structure of the economy, but rather in a consolidation of the preexisting structure dominated by engineering; however, the development during 1980–94 has been a modest increase in the share of employment in knowledge intensive service industries in parallel with the general increase in service sector employment. Swedish production of high-technology products as a share of all manufacturing production also increased from 1993 (8.8 percent) to 1996 (12.5 percent). However, these exports were dominated by the two high-technology sectors in which Sweden was already specialized, that is, telecommunications equipment and pharmaceuticals.

The Swedish economy is experiencing a kind of paradox similar to the so-called European paradox, where there are high investments in knowledge intensive activities such as research and innovation efforts, but seemingly limited payoffs in the form of innovative output and employment. Partly, this can be explained by the continued importance of industries that are not so knowledge-intensive. Also, according to Edquist and Hommen, the paradox is in part linked to globalization processes in the sense that Swedish multinational corporations and in particular those specialized in high technology simultaneous with domestic investments have also pursued a strategy of foreign direct investment.

Government

Sweden is also known as one of the prime examples of social policies for wealth distribution and interceder equality. State-administered minimum old-age pension was instituted in 1946 and followed by universal child benefits (1947), Occupational Safety and Health Act (1949), three-week statutory holiday (1951), compulsory health insurance (1955), compulsory nine-year education (1960 ), and a so-called million-homes housing program (1965–74).

Specific reforms focusing on families and female labor force participation include extension of maternity leave to six months (1963), separate taxation for married couples (1971), Parental Leave Act (1974), Working Environment Act (1977), Equal Opportunities Act (1979), and separate paternity leave (1995). From 2003 onward, the social policies have been organized as a comprehensive public health policy, meaning that there are 11 domains of objectives for both the prevention and amelioration of social problems (ranging from participation and influence in society to reduced consumption of tobacco and alcohol) where public health efforts are to be concentrated.

Swedish politics have been dominated by long and relatively stable government structures firmly held by the Social Democratic Party, who until 2006 were in power during all but nine years since 1932. While most of the other political parties to a large extent share the basic ideas behind the welfare state, there are profound differences regarding funding principles, extent of coverage, and so forth. In 2006 a conservative Alliance for Sweden won the general elections and ousted the Social Democrats. This led to a series of liberalization and privatization measures targeted at the public sector, although the Social Democrats had initiated a number of modest reform processes already prior to the power shift.

As for the current and future prospects of the Swedish economy and its welfare state provisions, the Organisation for Economic Co-operation and Development (OECD) has evaluated the macroeconomic performance as “excellent,” with high rates of growth, low unemployment, and stable inflation expectations. They also point out challenges such as employment rates not having recovered to traditionally high levels, with unemployment rates particularly high among immigrants and young persons. In addition, disability and sickness rates are high in international comparison.

Bibliography:

  1. David Domeij, “Rising Earnings Inequality in Sweden: The Role of Composition and Prices,” Scandinavian Journal of Economics (v.110/3, 2008);
  2. Christian Dufour, “Industrial Relations in Small Companies: A Comparison: France, Sweden and Germany,” Work and Society (v.56, 2007);
  3. Edquist and L. Hommen, eds., Small Country Innovation Systems: Globalization, Change and Policy in Asia and Europe (2008);
  4. International Business Publications, Doing Business and Investing in Sweden Guide (International Business Publications USA, 2007);
  5. Inge Ivarsson, “Transnational Corporations and the Geographical Transfer of Localised Technology: A Multi-Industry Study of Foreign Affiliates in Sweden,” Journal of Economic Geography (v.2/2, 2002);
  6. Magnus Jonsson and Paul Klein, “Tax Distortions in Sweden and the United States,” European Economic Review (v.47/4, 2003);
  7. Organisation for Economic Co-operation and Development (OECD), Economic Survey of Sweden, 2007 (OECD, 2007);
  8. Gerhard Schnyder, Does Social Democracy Matter?: Corporate Governance Reforms in Switzerland and Sweden (1980–2005) (University of Cambridge, 2008);
  9. Sundin and S. Willner, Social Change and Health in Sweden (2007).

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