A brief introduction to derivatives and swaps

Almost all lawyers have heard about derivatives and swaps. Not all that many are aware what they are about. This is an attempt to introduce these concepts to those who would like to know a little about the basics of derivatives and swaps. Admittedly, an article of this length will not even scratch the surface.

Derivatives. Derivatives is a generic term used to describe futures, options, swaps and similar transactions. A financial derivative product is called a derivative because it is derived from another financial product. For example, an option to buy a share at some point in the future is a financial product derived from the underlying share. Similarly, a swap on an interest rate is a product derived from the underlying loan. This is the reason for the use of "derivatives" as a generic term.

With the exception of interest swaps, most derivatives are contracts for the difference between the agreed future price of an asset on a future date, and the actual market price on that date. In this article, we limit ourselves to swaps.

Swaps. In a basic swap transaction, one party who has an obligation that it does not want, exchanges it with another party for an obligation which the other party does not want. The purpose of the swap is to reduce the inherent risks or costs of certain financial transactions for both parties. There are several types of swaps, one of the more common of which is an interest rate swap. An interest rate swap is simply an exchange of the rate of interest that a borrower is paying, for a different rate of interest.

It is a contract in which each party agrees to make periodic payments to the other equal to interest on agreed principal sums, where the interest on both sums are calculated on a different basis. The example given by noted author Philip Wood is where X Co. and Y Co. have each borrowed 100 from third party lenders. X Co.’s loan bears a floating rate interest at LIBOR plus one percent, and Y Co.’s loan bears fixed interest at 10 percent. Under the interest swap contract, Y Co. pays X Co. periodic amounts equal to the floating rate interest on 100. X Co. pays Y Co. period amounts equal to the fixed rate interest on 100, plus an extra amount representing Y Co.’s profit. Basically, X Co. agrees to pay Y Co. the interest that Y Co. has to pay on its loan. In turn, Y Co. agrees to pay X Co. the interest that X Co. has to pay on its loan.

The usual reason for transactions such as this is that Y Co. is a company of high credit standing which can borrow at a fixed rate. Y Co. is a little known company which cannot borrow cheaply, and must pay a floating rate of interest. If interest rates move upwards, then the fixed rate of interest would probably be lower than the floating rate of interest that X Co. would otherwise have been paying. Upon the other hand, if interest rates do not rise, but actually fall or remain the same, X Co. will be paying more for its borrowing than if it had done nothing.

Hedging and speculation. On the basis of the general rule applicable to financial institutions supervised by the BSP, financial derivatives may be used only for hedging purposes and not for speculation. There is a fine line between hedging and speculation. However, very often the distinction is blurred. The notion of hedging is accordingly in need of less ambiguity and more simplification. In some instances, what one swap practitioner will consider as hedging, another might on an equally reasonable basis, regard as speculation.

Hedging. A swap results in either a reduction of the market risk for the parties, in which case it is hedging, or an increase in the market risk, in which case it is speculation. Put more simply, hedging involves a reduction of risk, while speculation creates additional risks. Hedging is done for strategic, rather than speculative, purposes. For example, X has a financial instrument that would show a profit or loss depending on market movements. X purchases another instrument which will show a profit if the first shows a loss. The second instrument, sought to balance the effect of the first, is a hedge.

Hedging is like betting on a race between two horses. You place a bet on the black horse, but you are worried you will lose your bet if the white horse wins. So you "hedge" your risk by putting a bet on the white horse that will produce a large enough win to equal the cost of your stake on betting on the black horse.

Speculation. Speculation creates additional risks for parties. It is a conscious and deliberate effort to expose oneself to market uncertainties with the intention of acquiring an economic benefit. Like hedging, speculation has two different sides: the drawback of obtaining a chance of deriving a profit from favorable changes in the market, and the risk that the party’s economic expectations will not be met.

An example of a swap entered into for speculative purposes would be a Philippine Peso-Japanese Yen swap by a Philippine company which has no liabilities or assets on its balance sheet denominated in yen. It is clear that the only purpose that motivates the opening of that swap position is to derive a profit from the favorable movement of the yen, which the company speculates will ultimately turn in its favor.

Applicable regulations. The proper legal environment in the Philippines for swaps and derivative transactions by financial institutions supervised by the BSP has been in place for quite some time. As early as 1995, the BSP issued Circular No. 107 on financial derivative products. In 2001, it issued BSP Circular No. 297, which amended the first circular.

Uniform documentation. There is a wide variety of available derivatives on the market today, and their numbers are limited only by the imagination and ingenuity of those who craft them. Documentation for swaps and derivatives may be tailored to fit the circumstances of a particular transaction. However, the usual practice is to base the agreement of the parties on a standard agreement that will cover all transactions of the same nature between the same parties. Each individual transaction is then documented by an exchange of confirmations, that is, written memoranda documenting the different details of a specific transaction.

The standard form utilized in the Philippines is that developed by the International Swap Dealers Association, called ISDA for short. It is used, not only because it is the one generally utilized elsewhere, but because Annex A to Circular No. 107 prescribes its use.

The Master Agreement is not necessarily adopted by parties in exactly the same form and tenor. The terms can be negotiated. Clearly, the negotiation of the Master Agreement becomes a matter of importance because it sets the parameters for derivatives dealings between the parties in the future.

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(The author is a senior partner of Angara Abello Concepcion Regala & Cruz Law Offices (ACCRALAW). He may be contacted at tel. no. 830-8000; fax nos.: 894-4697/816-0119 or e-mailed at [email protected]/[email protected])