Advantages & Disadvantages of Swaps

1. Introduction

Like any financial tool, Swaps are a double-edged sword. They provide long-term protection but come with significant risks, as seen in the 2008 Financial Crisis.

2. Advantages

1. Long Term Hedging:
   • Forwards/Futures are typically for 1-3 months.
   • Swaps can last for 10-30 years. Perfect for infrastructure projects.
2. Lower Cost:
   • By using Comparative Advantage, both parties save on interest costs (often 0.5% or more).
3. Flexibility:
   • Since it is an OTC contract, you can customize the amount, dates, and rates perfectly.

3. Disadvantages

1. Counterparty Credit Risk:
   • If the other bank moves bankrupt after 5 years, your hedge collapses. (This happened with Lehman Brothers).
2. Lack of Liquidity:
   • You cannot easily "sell" a swap to someone else. Getting out of a swap early usually requires a "cancellation fee".
3. Complexity:
   • Valuation of swaps requires complex mathematical models.

4. Comparison Table

5. Exam Notes: Writing the Answer

Question: "Critically examine the utility of Swap contracts." (10 Marks)

Answering Structure:

1. Pro: Focus on "Long Term Nature" (unlike futures).
2. Con: Focus on "Default Risk" (OTC nature).
3. Example: "An airline determining fuel costs for 10 years would use a Swap, not a Future."

6. Quiz Time! 🎯