How are swaps priced and traded?
Curious about swaps
Swaps are priced and traded in both overthecounter (OTC) markets and, for some standardized swaps, on organized exchanges. The pricing and trading processes differ depending on whether the swap is traded OTC or on an exchange. Here's an overview of how swaps are priced and traded in both scenarios:
OvertheCounter (OTC) Trading:
1. Negotiation and Customization:
In OTC markets, swaps are highly customizable. Parties interested in entering into a swap negotiate the terms of the contract directly with one another or with the assistance of an intermediary, such as an investment bank or dealer.
2. Terms and Conditions:
The counterparties agree on key terms and conditions, including the type of swap, notional amount, interest rate or reference rate, payment frequency, payment dates, and any other relevant terms. These terms are specified in a swap confirmation document.
3. Pricing and Valuation:
Once the terms are agreed upon, the parties or their intermediaries calculate the initial and subsequent cash flows associated with the swap. Pricing models and market data are used to determine the present value of these cash flows.
4. Market Data and Benchmark Rates:
Swaps often reference benchmark rates, such as LIBOR, SOFR, or EURIBOR. Current market rates for these benchmarks play a key role in determining the pricing of the swap.
5. Counterparty Credit Assessment:
Parties assess each other's creditworthiness, and credit risk considerations are factored into the pricing of the swap. Parties with higher credit risk may need to pay a credit risk premium.
6. Collateralization:
Parties may agree to post collateral to mitigate credit risk. Collateral requirements and agreements are typically specified in a Credit Support Annex (CSA) or similar document.
7. Execution:
Once pricing and terms are finalized, the swap is executed, and the swap confirmation is signed by both parties. This confirmation document details the specific terms of the swap and serves as a legal record of the transaction.
8. Ongoing Valuation and Settlement:
Throughout the life of the swap, parties calculate the daily or periodic value of the swap (marktomarket). Margin calls may be made to ensure that collateral is maintained at an appropriate level.
ExchangeTraded Swaps:
1. Standardization:
Some swaps, particularly interest rate swaps, are standardized and traded on organized exchanges. These standardized swaps have predefined terms and conditions, making them more liquid and transparent.
2. Listing and Trading:
Exchangetraded swaps are listed on organized exchanges, such as the Chicago Mercantile Exchange (CME) or Eurex. Traders can access these markets through their brokerage accounts.
3. Order Placement:
Traders place orders to buy or sell standardized swaps on the exchange, specifying the desired terms, such as contract size and maturity.
4. Central Clearing:
Exchangetraded swaps are often subject to central clearing, where a clearinghouse acts as the counterparty to both sides of the trade. This reduces counterparty risk.
5. Price Transparency:
Exchangetraded swaps offer price transparency, as market participants can see realtime prices and trading volumes. This transparency enhances market efficiency.
6. Settlement:
Upon execution of a trade, the exchange facilitates the settlement process, ensuring that the terms of the swap are met.
7. Margin and Collateral:
Exchangetraded swaps may require initial margin and variation margin to cover potential losses. Margin requirements are set by the exchange and are standardized.
8. Regulatory Oversight:
Exchangetraded swaps are subject to regulatory oversight, and exchanges must adhere to rules and regulations governing trading, clearing, and reporting.
The choice between OTC and exchangetraded swaps depends on the specific needs and preferences of market participants. OTC swaps offer greater flexibility and customization but require thorough negotiation and credit risk assessment. Exchangetraded swaps provide standardized, transparent trading but may have limited customization options. Both markets play essential roles in the global derivatives market.