Saturday, 31 December 2016

Risks Involved In Swap Business For A Swap Bank

While the earnings of the swap bank are from the bid-ask spread of swaps and the fees charged (upfront fees), it has to entail the following risks, which are inherent to the swap business and are mostly inter-related:

1. Interest Rate Risks: Interest rate risk arises mostly on fixed rate legs of swaps. While the floating rate interest can be periodically adjusted to the prevailing interest rates, the fixed rate in the market not accompanied by a change in the yield of debt instruments of the same time period as the interest rates will entail interest rate losses to the bank. Unless the swap bank is fully hedged, losses will be incurred.

2. Currency Exchange Risk: Currency exchange risks happen when there is an exchange rate commitment given to one party and there is a steep change in the exchange rate between the currencies in the swap. If the swap bank is not able to match the counterparty well in time, it will incur losses due to the exchange rate difference.

3. Market Risks: Market risks occur when there is difficulty in finding counterparty to a swap. Usually, longer maturity swaps have less takers and vice versa. Lower the number of takers, higher the risks of losses.

4. Credit Risks: Credit risks are those risks which the swap bank has to bear in case the counterparty to a swap defaults on payment due to bankruptcy or any other defaults, legal or otherwise. The bank continues to the obliged to pay the other party of the swap, irrespective of the fact whether the former party defaulted or not. Market risks and credit risks together amount to default risks of the bank.

5. Mismatch Risk: Mismatch risks take place when the swap bank comes across mismatches in the requirements of both counterparties to the swap. Usually, banks have a pool of swaps and have no difficulty in finding matches, but if no party is found, the risk of mismatch losses is there. This risk is further aggravated in case one of the parties defaults.

6. Basis Risks: Basis risks take place mostly in floating-to-floating rate swaps, when both the sides are pegged to two different indices the sides are pegged to two different indices and both the indices are fluctuating and there is no proper correlation between both.

7. Spread Risk: Spread risks happen when the spread changes over the time period the parties are matched. The spread risk is not the same as interest rate risk, as spreads may change as a result of change in basis points, while the interest rate may still remain constant.

8. Settlement Risk: Settlement risks take place when the payments of currency swaps are made at different times of the day mainly because of different settlement hours in capital markets of two countries involved in the currency swap. If a limit on the size of the settlement is placed for each day, this risk is minimized.

9. Sovereign Risk: Sovereign risks are those risks that can take place if a country changes its rules regarding currency deals. It mostly happens in the underdeveloped or developing countries which tend to have more political instability than the developed world.

Friday, 30 December 2016

Various Functions Performed By Financial System

The functions performed by a financial system are: 

The Savings Function:

The public savings find  their way  into  the hands of  those  in production  through  the financial system. Financial  claims  are  issued  in  the money  and  capital markets which promise  future income flows. The funds in the hands of the producers result in production of better goods and services,  increasing  society's  living  standards.  When  savings  flows decline,  however,  the growth of investment and living standard begins to fall. 

Liquidity Function:

Money in the form of deposits offers the least risk, of all financial instruments. But its value is most  eroded  by  inflation.  That  is  why  one  always  prefers  to  store  the  funds  in  financial instruments  like  stocks,  bonds,  debentures,  etc.  The  compromise  one  makes  in  such investments is (1) that the risk involved is more, and (2) the degree of liquidity, i.e. conversion of  the  claims  into  money  is  less.  The  financial  markets  provides  the  investor  with  the opportunity to liquidate the investments. 

Payment Function:

The  financial system offers a very convenient mode of payment  for goods and services. The 
cheque system, credit card system et al are  the easiest methods of payments  in  the economy. The  cost  and  time  of  transactions  are  drastically  reduced.  In  India,  the  cheque  system  of payment  is  widely  practiced.  The  credit  card  system  has  entered  only  urban  India  and  is widely used in these areas for payments of consumption expenditure. 

Risk Function:

The  financial  markets  provide  protection  against  life,  health  and  income  risks.  These are accomplished  through  the  sale  of  life  and  health  insurance  and  property  insurance policies. The financial markets provide immense opportunities for the investor to hedge himself against or reduce the possible risks involved in various investments. 

Policy Function:

India  is  a mixed  economy.  The  government  intervenes  in  the  financial  system  to influence macroeconomic variables like interest rates or inflation. In 1996-97, by bringing about several cuts in the CRR from 12% to 10% the government, the RBI has tried to force the interest rates down and increase the availability of credit to the corporates at cheaper rates. 

Modern  day  economies  require  huge  sums  of money  for  investment  in  capital  assets (land, equipment,  factory,  etc.) which  are  then  used  for  providing  goods  and  services. The  funds required  are  so  huge  that  it  is  not  possible  for  a  single  government/firm  to provide  for  the requirement.  By  selling  financial  claims  like  stocks,  bonds,  etc.  the required  funds  can  be quickly  raised  from  a  variety  of  investors.  The  business firm/government  issuing  such  a financial claim then hopes to return the borrowed funds from expected future inflows. Indeed, we see that the financial markets within the financial system have made possible the exchange of  current  income  for  future  income  and transformation of  savings  into  investments,  so  that production and income grow. 

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