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.

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