We recently used two thick tight blue rubber bands to turn two of our large-breed kids into wethers. They're likely to weigh more than their moms before long and then, sometime in the Fall, I will bite the bullet and haul them off to harvest. Earlier on, we toyed with the idea of trading market-ready goats with other goat herders so neither of us would have a familiar goat's name on our dinner plates. As they continue nibbling our hedges, we haven't arranged that swap ...
which brings me to today's topic -- swaps. Let's say your business has an adjustable-rate loan that's making you uncomfortable because you think interest rates are going to rise. You run into another businessperson who has a fixed-rate loan that's making her nervous because she thinks interest rates will remain lower than hers. She has what you want and you have what she wants. The rest of the loan terms happen to be exactly the same, so you agree to a trade. This is an interest rate swap, more precisely I suppose, a payment swap. You agree to make her loan payments and she agrees to make yours.
This example is a bit too simple, isn't it? To be more realistic, let's say the loans are a little different, as normally would be the case. To even things out, one of you pays the other some extra money, but as in the first case you agree to make her payments and she agrees to make yours. This swap is more like the ones we see in the real commercial world.
A few years go by, each of you has made payments as agreed and you're both happy with your deal, so you're open to expanding the concept. Your business is manufacturing and selling National Football League memorabilia. Unfortunately, you have a bad feeling about the coming season. You think the NFL is going to have a boring time, while you expect the American Football League to be exciting, which you think means people are going to buy the NFL stuff someone else makes and not your material. An acquaintance is convinced you're wrong and says, "Look, let's make a deal. I'll pay you $50,000. If the NFL has a miserable season, you keep the money, but if the AFL has a lousy time while the NFL fills each stadium to capacity we'll split your profits." "All right," you say. You've hedged some of your risk, swapping what you think are unlikely profits for a certain cash payment.
"So?" asks Virginia, "what are you getting at?"
Well, after thinking through those examples, you might imagine the multitudes of swap arrangements businesspeople have come up with -- tied to weather, oil prices, crop success, financial indices, sport scores, and thousands of other measures. Originally designed to cover true business risks, the arrangements grew into distantly contingent game-playing that sometimes merged with pure gambling.
You may have heard about swaps and hedges (and hedge funds), which have taken some of the blame for the financial crisis we're trying to shuffle past. The financial reform bill approved by the House and Senate conference committee early Friday morning includes 400 pages of new rules regulating swaps. The book I'm writing on that bill is supposed to explain these new rules, among all the other changes stuffed onto the bill's 2000 pages.
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