Loans and financial matters

We took our first look at the concepts of pricing and valuation when we examined forward contracts on assets and FRAs, which are essentially forward contracts on interest rates. Recall that a forward contract requires no cash payment at the start and commits one party to buy and another to sell an asset at a later date. An FRA commits one party to make a single fixed-rate interest payment and the other to make a single floating- rate interest payment. A swap extends that concept by committing one party to making a series of floating payments. The other party commits to making a series of fixed or floating payments. For swaps containing any fixed terms, such as a fixed rate, pricing the swap means to determine those terms at the start of the swap. Some swaps do not contain any fixed terms; we explore examples of both types of swaps.
All swaps have a market value. Valuation of a swap means to determine the market value of the swap based on current market conditions. The fixed terms, such as the fixed rate, are established at the start to give the swap an initial market value of zero. As we have already discussed, a zero market value means that neither party pays anything to the other at the start. Later during the life of the swap, as market conditions change, the market value will change, moving from zero from both parties’ perspective to a positive value for one party and a negative value for the other. When a swap has zero value, it is neither an asset nor a liability to either party. When the swap has positive value to one party, it is an asset to that party; from the perspective of the other party, it thus has negative value and is a liability.
We begin the process of pricing and valuing swaps by learning how swaps are comparable to other instruments. If we know that one financial instrument is equivalent to another, we can price one instrument if we know or can determine the price of the other instrument.

Just as currencies, interest rates, and equities can be used to structure swaps, so too can commodities and just about anything that has a random outcome and to which a corporation, financial institution, or even an individual is exposed. Commodity swaps are very commonly used. For example, airlines enter into swaps to hedge their future purchases of jet fuel. They agree to make fixed payments to a swap dealer on regularly scheduled dates and receive payments determined by the price of jet fuel. Gold mining companies use swaps to hedge future deliveries of gold. Other parties dealing in such commodities as natural gas and precious metals often use swaps to lock in prices for future purchases and sales. In addition, swaps can be based on non-storable commodities, like electricity and the weather. In the case of the weather, payments are made based on a measure of a particular
weather factor, such as amounts of rain, snowfall, or weather-related damage. We have now introduced and described the basic structure of swaps. We have made many references to the pricing and valuation of swaps, and we now move on to explore how this is done.

Country risk, also called political risk, is the uncertainty of returns caused by the possibility of a major change in the political or economic environment of a country. The United States is acknowledged to have the smallest country risk in the world because its political and economic systems are the most stable. Nations with high country risk include Russia, because of the several changes in the government hierarchy and its currency crises during 1998, and Indonesia, where there were student demonstrations, major riots, and fires prior to the resignation of President Suharto in May 1998. In both instances, the stock markets experienced significant declines surrounding these events. Individuals who invest in countries that have unstable political- economic systems must add a country risk premium when determining their required rates of return.
When investing globally, investors must consider these additional uncertainties. How liquid are the secondary markets for stocks and bonds in the country? Are any of the country’s securities traded on major stock exchanges in the United States, London, Tokyo, or Germany? What will happen to exchange rates during the investment period? What is the probability of a political or economic change that will adversely affect your rate of return? Exchange rate risk and country risk differ among countries. A good measure of exchange rate risk would be the absolute variability of the exchange rate relative to a composite exchange rate. The analysis of country risk is much more subjective and must be based on the history and current environment of the country.
This discussion of risk components can be considered a security’s fundamental risk because it deals with the intrinsic factors that should affect a security’s standard deviation of returns over time. In subsequent discussion, the standard deviation of returns is referred to as a measure of the security’s total risk, which considers the individual stock by itself—that is, it is not considered as part of a portfolio.