Swap Contract

Swap Contract

Swaps are investment instruments contracts between two parties that agree to exchange a series of cash flow over a specific period. There are different types of swaps contracts, which include currency, zero-coupon, total return swaps, credit default swaps (CDS), commodity, and interest swap.

The credit default swaps allow an investor to swap his credit risk to another investor who offers insurance in case of default of the borrow. Credit default swaps were one of the instruments in the derivatives markets to be blamed for 2007 to 2010 nationwide financial crisis in the United States. As the financial crisis hit the economy, the net worth of commercial banks and other financial institutions deteriorated due to increase loss from subprime mortgages such that those companies in credit default swap providing insurance would have to pay their counterparties. The outstanding volumes of CDS increased with an approximate of debt covered by CDS ranging from $33 to 47 trillion in 2008. There was no central clearinghouse for CDS that lead CDS to been unable to perform its obligation under the contracts..

Almost all investment banks were affected, but the great impact was felt by Lehman Brother investment bank that owed more than $ 600 billion in debt, which CDS settled $ 400 million. Companies offering insurance to banks such as the American insurance group and municipal bond insurance association lacked enough capital to clear debt causing the federal reserve to intervene. Banks used CDS to insure complex financial products since the investor was no longer interested in the swap deal, and the bank starts holding more capital and becoming risk-averse while granting a loan. The decision affect the amount of money available for trading as banks reduce the risk on loan given while being prohibited from using customer deposit to invest in the swap.