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Types of Coupon Swap Futures

Updated on 2013-05-20 by Guest

Risk hedging had been made much easier with the evolution of derivatives in the capital markets. Derivatives are financial instruments which derive their value from the underlying asset. With growing investments in capital markets across the world, the numbers of derivative instruments that get evolved are huge. However the basic forms of derivatives such as forwards, futures, options and swaps still retain their attractiveness to investors.

Futures are the most commonly used derivatives instruments by individual and institutional investors to hedge their funds against risk. Futures are agreements by which the buyer agrees to purchase the underlying asset, a physical commodity or a financial asset, at a predetermined price and future date. On the other hand, swaps are derivative instruments which involve exchange of one financial asset or security for another. While futures are exchange traded derivatives free of credit default risk, swaps usually occur over the counter between two individual parties without the intermediation or regulation of an exchange.

The market for swaps is ever evolving with changing investment objectives, currency requirements, maturity needs and quality issues. With such ever growing needs, swaps instruments have moved far ahead from their basic plain vanilla interest rate and currency swaps to hybrid categories like catastrophe swaps, substitution swaps, volatility swaps, bond swaps and the like. One such commonly used hybrid swaps are the coupon swaps or zero coupon swaps which are based on the working of deep discount or zero coupon bonds. Such coupon swaps are gaining greater attraction amongst the firms and financial institutions especially by their ability to adjust to inflation rates.

Coupon swaps are useful for corporates which had purchased deep discount bonds or zero coupon bonds but do not want to wait till the bonds pay off at the end of maturity. In such situations, firms may enter into zero coupon swaps through which the firm would get floating rate interest payments at periodic intervals. For example, if two parties enter into coupon swap for three years on notional principal of $1,000,000 and party A agrees to pay fixed interest rate at 3 percent deep discount. On the other hand party B agrees to pay floating interest rate equivalent to the annualized rate of interest based on the discounted cash flows of zero coupon rate spread over three years time period. Further the possibility of credit default risk that the Party A may not be able to repay the lump sum fixed payment at the end of maturity should also be included in calculating the floating payments.

Though the swaps had been very popular among the investors and corporate for trading and hedging, the market had always looked out for more generic, standardized products to reduce the risk. The market participants always favored the use of capital efficient and low risk products such as futures, which through regulation of stock exchanges had completely eliminated credit default risk. This has led to the emergence of new era of swap futures which is a hybrid security which combines the properties of swaps and the regulation and reduced risk of futures. Investors now engage heavily in trading in interest rate swap futures to tap these advantages.

In line with this development, futures had been developed on all types of interest rate swaps ranging from plain vanilla swaps to complicated varieties of catastrophe and volatility swaps. This also includes futures on the popular zero coupon swaps. The types of zero coupon swap futures are:

1. General coupon swap futures
These futures derivatives are based on the normal zero coupon swaps as explained in the example above. Through the exchange of periodic floating rate payments for lump sum fixed rate payment at the end of maturity, such type of futures ensure effective hedging of credit and interest rate exposures. With the coupon swap tied to the security of futures, the derivative instrument is now transparent and totally free of credit risk. This further paves way for better rates of interest on the floating rate payments which need not be discounted for credit default risk of the other party.

2. Reverse coupon swap futures

This type of swap futures is based on the reverse coupon swaps in which the fixed interest rate payment on the swap agreement is made in lump sum at the beginning of the contract period itself. Thus the other party gets assured fixed rate payments in lump sum, while he makes periodic floating rate payments on the swap. Such futures are comparable to the price and yield characteristics of plain vanilla interest rate swaps. However, due to exchange regulation of the swap futures, the administrative costs are reduced on the swap agreements.

3. Exchangeable coupon swap futures

In such coupon swap futures, the floating interest rate payments are made at periodic intervals say monthly, quarterly, half yearly or annually depending on the terms of the agreement. On the other hand, the fixed rate payments are made at fixed intervals or for fixed number of times during the maturity period. For example, if the swap agreement is for three years, then the lump sum fixed payments may be divided to be made once in a year or three times during the maturity period.

4. Inflation indexed coupon swap futures

Inflation indexed coupon swaps are to the rescue of those investors who intend to hedge their investments against inflation rates. In such swap futures, the fixed rate payer makes the lump sum payment based on the coupon rate of the swap to the floating rate payer. On the other hand, the floating rate payer makes periodic payments based on the inflation indexed rate on the notional principal to the fixed rate payer. Thus the party receiving floating rate payments is hedged against the inflation effectively.

With the advent of such hybrid derivatives, market is all the more efficient and optimal for the investors who look out to financial securities with varied investment objectives. In addition to reduced credit risk and lowered initial margin requirements, the coupon swap futures also have operational advantages as they are systematically regulated by the exchanges.

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