ISDA®
ISDA - INTERNATIONAL SWAPS AND DERIVATIVES ASSOCIATION, INC.
NEWS RELEASE
For Immediate Release, Wednesday,
September 22, 2010
For More Information, Please
Contact:
Cesaltine Gregorio, ISDA New York,
+1 212-901-6019, cgregorio@isda.org
Deirdre
Leahy, ISDA New York, +1 212-901-6021, dleahy@isda.org
Donna
Chan, ISDA Hong Kong, +852 2200 5906 dchan@isda.org
Rebecca O'Neill, ISDA London, +44
203 088 3586, roneill@isda.org
ISDA Publishes Research Notes Analyzing
Swap Pricing and Speculation
NEW YORK, Wednesday,
September 22, 2010
– The International Swaps and Derivatives Association, Inc. (ISDA) today 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.”
This
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.
ISDA Research Notes began publication in December 2008. 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.
In addition to his responsibility for ISDA’s
education, survey, and risk management research activities, Dr Mengle also
teaches courses in economics, statistics and risk management at the Fordham
University Graduate School of Business. He holds a B.A. from The Citadel and a
Ph.D. in economics from the
ISDA Research Notes are available at www.isda.org/researchnotes/isdaresearch.html.
About ISDA
ISDA, which represents participants
in the privately negotiated derivatives industry, is among the world’s largest
global financial trade associations as measured by number of member firms. ISDA
was chartered in 1985, and today has over 830 member institutions from 57
countries on six continents. These members include most of the world’s major
institutions that deal in privately negotiated derivatives, as well as many of
the businesses, governmental entities and other end users that rely on
over-the-counter derivatives to manage efficiently the financial market risks
inherent in their core economic activities. Information about ISDA and
its activities is available on the Association's web site: www.isda.org.
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Derivatives Association, Inc.