Financial derivatives: swaps GFS/EDp-course 2012 Financial derivatives: swaps 13.5.16 derivatives

What are derivatives ? Derivatives are financial instruments linked to a specified financial instrument or indicator or commodity, through which specific financial risks can be traded in financial markets in their own right Derivatives are financial tools that are used to manage risk or to take risk. The main classes of derivatives are swaps, options and futures, but there are many types of derivatives in each class and even products made up of combinations among the classes. Financial derivatives and, in particular, currency and interest rate swaps, are used by Governments as financial tools in debt management – mainly to hedge against exchange rate and/or interest rate exposure.

Why swaps ? There are two aspects of swaps that are to be considered for EDP purposes: The existence of so called off-market swaps and their treatment in national accounts 2) Impact on the measurement of government debt Cases where liabilities are denominated in foreign currency and then exchange through contractual agreements into another foreign currency or domestic currency

What are Swaps ? ESA 2010 § 5.210 gives the following definition of a swap: "Definition: swaps are contractual arrangements between two parties who agree to exchange, over time and according to predetermined rules, streams of payment on an agreed notional amount of principal. The most common types are interest rate swaps, foreign exchange swaps and currency swaps. “

What are IRS An interest rate swap (IRS) is an agreement between two parties to exchange interest payments on the same notional amount for a fixed period of time. The notional amount is not exchanged. The fixed rate is agreed at inception and the floating rate is a short term rate observable on the market Payments based on the fixed interest rate and payments based on the floating interest rate are netted and only a net value is transferred from one party to another.

IRS an example GFS 2013 week2, ch. 13.5.16

Currency swap A currency swap is an agreement between two parties to exchange principal amounts in two currencies at inception, exchange interest payments during the life of the contract and re-exchange the principal amounts at maturity. A currency swap has a similar feature as an IRS swap, where each leg of the swap is denominated in a different currency. A currency swap therefore has two principal amounts. The exchange of principal at inception is optional, and it happens that the parties exchange principal amounts at maturity only.

Currency swap, an example

ESA 2010 4.47 Payment resulting from any kind of swap arrangement is recorded as a transaction in financial derivatives in the financial account, and not as interest recorded as property income. Transactions under forward rate agreements are recorded as transactions in financial derivatives in the financial account, and not recorded as property income. 20.188 Settlements on swap transactions are not considered as property income in the ESA. The settlements related to financial derivatives are financial transactions, to be recorded at the time of the effective exchange of financial instrument.

Off-market swaps Swaps are generally agreed using the current market fixed interest rate observable at inception, with the consequence that the market value is null at inception. Off-market IRS swaps are swaps that use an interest rate agreed at inception which deviates from the current rate on the market. Off-market swaps have a non zero market value at inception. MGDD part VIII.3.3 §35: if at inception the benefiting party provides to the losing party the compensation in the form of a lump sum paid in cash, the existence of a loan is evident.

Off- market swaps II Cases when this compensation may be subject to specific agreements (instalments payments, writing off of liability, etc.) The “counterpart” of this unbalanced payment linked to other government operations with no evident link with the swap. Also complex arrangements, such as a combination of different swaps and/or other instruments, in a “package”, which avoids recording an immediate negative impact in government accounts. This may make more difficult to identify the “real” rebalancing element MGDD part VIII.3.3 §46: an off-market swap may also appear in the context of a renegotiation/restructuring of an on-going swap, such that a new swap would start with a negative value for government.

Of-market swaps III An off-market swap must be divided into two parts: a) A swap based on the prevailing spot market conditions, with nil market value at inception and recorded as financial derivative (AF.71). Thus, any change in the value of the swap will reflect the impact on the trend in market conditions. b) A loan (AF.4) for the initial market value at the start of the swap contract is recorded, amortised over the life of the instrument and on which interest should be imputed. This "loan component" is part of EDP debt. Part of the flows exchanged during the life of the contract is to be considered an amortisation of the loan, while another part is interest (calculated on the basis of the rate of the fixed paying leg), with an impact on government net lending/borrowing (B.9).

Off-market swap ESA2010 §20.133: Lump sums exchanged at inception on off-market swaps are classified as loans (AF.4) when the lump sum is received by government. Off-market swaps are partitioned in the balance sheet into a loan component and a regular, 'at-the-money' swap component.

Measurement of debt under EDP COUNCIL REGULATION (EC) No 479/2009, as amended reads: Liabilities denominated in a foreign currency, or exchanged from one foreign currency through contractual agreements to one or more other foreign currencies shall be converted into the other foreign currencies at the rate agreed on in those contracts and shall be converted into the national currency on the basis of the representative market exchange rate prevailing on the last working day of each year.

Liabilities denominated in the national currency and exchanged through contractual agreements to a foreign currency shall be converted into the foreign currency at the rate agreed on in those contracts and shall be converted into the national currency on the basis of the representative market exchange rate prevailing on the last working day of each year. Liabilities denominated in a foreign currency and exchanged through contractual agreements to the national currency shall be converted into the national currency at the rate agreed on in those contracts. GFS 2013 week2, ch. 13.5.16

VIII.3.2 Treatment of debt in foreign currency under EDP Debt measurement rules are applicable not only to currency swaps but also to Forex swaps and forward foreign exchange contracts. That is to derivative transactions involving exchange of capital amounts in different currencies. These rules concern currency swaps based on existing liabilities.