23 September 2010

ISDA publishes research notes analyzing swap pricing and speculation

 The International Swaps and Derivatives Association, Inc. (ISDA) announced the publication of two new additions to the ISDA Research Notes series: “The Value of a New Swap” and “The Economic Role of Speculation”.

“The Value of a New Swap” seeks to reconcile the theoretical and actual pricing of swaps at inception. Theoretically, swaps are priced at zero net present value at inception; this is also known as pricing at mid-market. But in practice, originating and executing a transaction involves costs that must be covered by the dealer that arranges it. It is therefore necessary to adjust the mid-market price to cover various costs and risks of transacting as well as provide a return to the dealer that makes a market; this is true not only of derivatives but of market making for all financial instruments. 

“The result is that the actual price agreed for the transaction is not the mid-market price, but typically either a bid price if the dealer is paying the fixed rate or an offer price if the dealer is receiving the fixed rate,” said David Mengle, ISDA Head of Research. “And because the actual price is the bid or offer price, the net present value to the dealer will be a positive amount and not zero.”

The note outlines a simplified example of setting the benchmark price based on a hypothetical yield curve and then using the benchmark as the starting point for the actual price, while describing some of the costs that the bid or offer price needs to cover.

 “The Economic Role of Speculation” provides a brief review on speculation and the important role it plays in the functioning of markets. “During times of economic stress, it is easy to quickly blame speculators for market instability,” said Dr Mengle. “In fact, speculation enhances liquidity and efficiency, and without it both hedgers and investors would find it more difficult and costly to do their jobs.”

This note considers various definitions of speculation and how it affects liquidity, efficiency and completeness in the market. It shows how speculation enhances market liquidity by making it possible to execute transactions more rapidly and at lower cost, by reducing bid-offer spreads and by making markets deeper and more resilient to shocks. Further, the existence of knowledgeable speculators makes markets more efficient via prices that reflect fundamental values more accurately. Finally, speculation makes markets more complete by increasing opportunities for other market participants, especially hedgers, to manage the risks they encounter in their financial activities.

The notes, which discuss public policy issues and market trends related to the privately negotiated derivatives industry, are published by ISDA’s Research Department in New York.

Full notes

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