The turnover in swaps in the Australian OTC market has increased by
almost a factor of 6 from 94/95 to 00/01, rising from about 1 billion
Australian dollars per day to almost 6 billion Austrian dollars per
day (?Australian Financial Markets?, RBA Bulletin, June 2002, page
13). Increased demand for private bonds is credited with fueling the
turnover in swaps because private bond investors hedge their positions
using swaps. The launch of two new swap products has also increased
the overall turnover volume. While credit default swaps have
experienced limited turnover so far (only 28 billion Australian
dollars annually for 00/01), overnight indexed swaps, which first
became available in Australia in late 1999, averaged 2 billion
Australian dollars of turnover per day in 00/01 (?Australian Financial
Markets?, RBA Bulletin, June 2002, page 13).
Overnight indexed swaps are a specialized form of fixed for floating
interest rate swap, which are financial instruments used by two
parties to exchange a floating-rate payment for a fixed-rate payment.
For an ordinary fixed for floating interest rate swap, the
floating-rate payment is based on a predetermined benchmark, typically
the 90-day Bank Bill Reference Rate. In contrast, overnight indexed
swaps use the Reserve Bank of Australia overnight cash rate as their
benchmark. Overnight indexed swaps are also generally of much shorter
duration than ordinary fixed for floating interest rate swaps, ranging
from one week to no more than one year. In addition, unlike ordinary
fixed for floating interest rate swaps that involve a stream of
payments, overnight indexed swaps consist of only one payment when the
swap matures. The payment reflects the total amount owed by one party
to the other based on the interest rates that prevailed during the
life of the swap. Banks and other financial institutions limit their
exposure to changes in the overnight cash rate by employing overnight
indexed swaps. Unlike bank bills, overnight indexed swaps have
minimal credit risk because no principle is exchanged, which makes
swaps especially attractive for this purpose.
Credit default swaps are contracts that are purchased by one party
from another to protect against adverse credit events occurring with a
defined third party. Banks and other financial institutions usually
use these swaps. The protection buyer pays the protection seller a
premium at regular intervals based on the amount of protection
purchased. In the event the third party experiences an adverse credit
event, such as bankruptcy, the protection seller pays the protection
buyer the purchase amount of protection. In return, the protection
buyer gives the protection seller a debt instrument, typically a bond,
issued by the third party. To maximize the value of the credit
default swap, the protection buyer will provide a bond to the
protection seller that lacks credit wrapping because such bonds will
have declined the most in value in response to the adverse credit
event. Credit default swaps allow the protection buyer to protect
itself against credit risk by purchasing protection that increases in
value when a defined third party decreases in creditworthiness.
Sincerely,
Wonko |
