Swap in Risk Reduction Derivative Markets Have Essay

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Swap in Risk Reduction

Derivative markets have evolved for the last few years and they currently offer contracts on any financial security. They offer contracts to hedge any investment risk. Swap is one such derivative that is used to hedge investment risk. Its use has gained popularity because it is one of the most efficient ways to hedge common and specific financial risks which characterize many portfolios (National Association of Pension Funds, 2005).

The term swap encompasses an extremely wide-ranging variety of instruments namely: interest rate swaps, inflation rate swaps, and portfolio swaps. Perhaps before we delve deep into the different types of swaps it is imperative that we ventilate what swaps really are. Swaps are contractual agreements between two parties to exchange future cash-flows on pre-determined dates over a specified period. Interest rate swaps is the most basic swap contract where party to the contract pays a fixed rate of interest while the other party pays a floating rate of interest.

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Swaps are tailored to the needs of the party paying floating rate of interest and the other paying fixed rate of interest (Whittaker, 1987). Swaps are therefore not traded on an exchange but over the counter (OTC). Brokers normally provide live tradable price quotes for a wide range of swaps. Brokers, by acting as intermediaries between investors, provide liquidity to the market. Swaps are flexible instruments because various details of swap can be amended on mutual agreement between the party paying the floating interest rate and the other paying fixed interest rate. Swaps can be used by companies, pension schemes and insurance schemes, and central banks. Companies can use swaps to reduce risks and manage their debts more efficiently for example by exchanging a floating interest rate exposure for a fixed interest rate exposure (Whittaker, 1987). Pension schemes and insurance schemes basically use swaps to manage interest rate risks. Finally, central banks use swaps to control their….....

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