2 forwards instead of a swap

CFA Level II Portfolio Management
#1

hi guys,

What is difference between 2 forwards and a normal Swap?

Swap is nothing but a series of forwards. So instead of creating a swap , I can create 2 forwards? Will there be any difference?

Thanks & Regards,

Manuag

#2

Twice the counterparty risk.

Also, if you are going to be doing a swap for more than one period, you are going to need 2n forwards for n periods of interest payments.

#3

If you have two forwards, then make sure that you have two guards and a center. Or you could go with three guards, if you want a smaller lineup.

Also, the best forwards you can get are Lebron and Timmy D.

#4

Yeah, I remember this reading. When you buy a swap, you are also implicitly making a loan to the counterparty at the risk free rate in addition to two forwards.

I think…

#5

I think of a swap as a pairs trade. If it’s an interest rate swap, you are long one bond and short another, and swap payments over the life of the swap represent differences in underlying cash flows. At swap termination, cash flows also represent the differences in principal value/capital gains (which are often going to be zero in interest-rate land, but not for something like an equity swap). But you could do the same thing with forwards - one is long and one is short.

With forwards though, you are likely going to have two counterparties, thus twice the counterparty risk.

If you want to get out of the double-forwards solution, you are going to have to negotiate with two counterparties, which may not agree on whether to let you out of the contract or at what price.

Your counterparties may require you to deposit margin (and more than someone worred about your performance in a swap), because each party is worried that you might not be able to come up with the principal in a forward contract, as opposed to just the difference in performance in a swap agreement. For each party to the forward, they have more money at risk if you can’t pay the forward than if you can’t pay the swap, so they may require more assurances, collateral, margin, or whatever.

Two forwards are a lot more hastle to manage than one swap.

#6

Besides 2x cpty risk, clearing fees are another difference. Why book two Forward Rate Agreements and pay 2x the fees (both to CCP and DCM) when you can book a single swap with 1 fee?

Its a whole new world since mandated swap clearing. And just wait till the SEFs mandate… Rates Salespeople better brush up their resumes.

#7

Thanks guys,

It is not needed to deposite margins in case of Forwrds so I think that should not be a problem. I feed counterparty risk and fee could be the deciding factors for choosing SWAP over 2 Forwards.

Another point, Forward contracts can be terminated in two ways below:

Physical delivery & Cash Settlement.

But SWAP on the other hand can be terminated in four ways:

  1. Mutual termination 2. Offsetting swap contract 3. Resale to a third party 4. Exercising a Swaption - an option to enter into an offsetting swap

I don’t know how crucial the above difference is? Any expert comment please?

#8

First off, don’t think that because a FRA is a “forward” you don’t need to post margin. Cpty risk is real, and Dealers take this seriously. Entering into a Bilateral FRA with a Dealer, you will have to post to them margin. Same goes for cleared FRA’s, you will post margin to the clearinghouse.

Now for Unwinds:

You do not have to take a FRA to settlement. Bilateral FRAs can be unwound, and novated just like swaps.

But, In the cleared space, the ONLY way to terminate a swap/FRA is to book a new completely offsetting trade, that will then Net down against the original swap at the clearing house.

Since mandatory clearing went live (in March for Level 1 (Dealers, High Volume Shops) and June for Level 2 (Everyone else) you CAN NOT novate a swap to a third party or simply mutually terminate a swap. Exercising the swaption is still viable, but in essence all you are doing is booking a new completely offsetting trade.

The IRS space is a changing animal… Manadatory clearing was a headache (kind of still is, but the Clearing Houses are now in the phase of helping clients develop new tools… not just setting up the pipelines for compliance) and the upcoming SEF mandate will flip it on its head.

I am a bit dissapointed in the CFA material when it comes to FRAs/Swaps/Swaptions. They basically give you a definition and a rediculously simple formula (well, its simple if you price them and build curves… :slight_smile: ). Very little input on the real world uses and how they are traded and facilitated.