Several securities firms have established sub- sidiaries that are separately capitalized so that they have a high credit rating which permit them to enter into swap transactions as a dealer.

Thus, it is imperative to keep in mind that any party who enters into aswapis subject to counterparty risk.

INTERPRETING A SWAP POSITION

There are two ways that a swap position can be interpreted: (1) a package of forward/futures contracts and (2) a package of cash flows from buying and selling cash market instruments.

Package of Forward Contracts Con

sider the hypothetical interest rate swap used earlier to illustrate a swap. Lets look at party Xs position. Party X has agreed to pay 10% and receive 6-month LIBOR. More specifically, assuming a $50 million notional amount, X has agreed to buy a commodity called "6-month LIBOR" for $2.5 million. This is effectively a 6-month forward contract where X agrees to pay $2.5 million in exchange for delivery of 6-month LIBOR. The fixed-rate payer is effectively long a 6-month forward con- tract on 6-month LIBOR. The floating-rate payer is effectively short a 6- month forward contract on 6-month LIBOR. There is therefore an implicit forward contract corresponding to each exchange date.

Consequently, interest rate swaps can be viewed as a package of more basic interest rate derivative instruments-forwards. The pricing of an interest rate swap will then depend on the price of a package of forward contracts with the same settlement dates in which the underlying for the forward contract is the same reference rate.

While an interest rate swap may be nothing more than a package of forward contracts, it is not a redundant contract for several reasons. First, maturities for forward or futures contracts do not extend out as far as those of an interest rate swap; an interest rate swap with a term of 15 years or longer can be obtained. Second, an interest rate swap is a more transactionally efficient instrument. By this we mean that in one transac- tion an entity can effectively establish a payoff equivalent to a package of forward contracts. The forward contracts would each have to be negoti- ated separately. Third, the interest rate swap market has grown in liquid- ity since its establishment in 1981; interest rate swaps now provide more liquidity than forward contracts, particularly long-dated (i.e., long-term) forward contracts.

Package of Cash Market Instruments