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Swaptions These are option contracts to enter into an interest rate swap contract at some
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future date or to cancel an existing swap in the future (iv) Swaps These are contracts between parties to exchange sets of cash ows based on a predetermined notional principal; only the cash ows are exchanged (usually on a net basis) with no principal exchanged Swaps are used to change the nature or cost of existing transactions, for example, exchanging xed-rate debt cash ows for oating rate cash ows Swap contracts are not exchange-traded, therefore they are not as liquid as futures contracts The principal types of swaps are interest rate swaps and currency swaps However, there are also basis swaps, equity swaps, commodity swaps, and mortgage swaps A brief description of seven swaps follows: 1 Interest rate swaps Interest rate swaps are used to manage interest rate risks, such as from oating to xed or xed to oating Periodic xed payments are made by one party, while another counterparty is obligated to make variable payments, depending on a market interest rate Master netting agreements are used to permit entities to legally set off related payable and receivable swap contract positions for settlement purposes 2 Foreign currency swaps Foreign currency swaps are used to x the value of foreign currency exchange transactions that will occur in the future Typically, principal is exchanged at inception, interest is paid in accordance with the agreed upon rate and term, and principal is re-exchanged at maturity 3 Fixed-rate currency swaps Fixed-rate currency swaps occur when two counterparties exchange xed-rate interest in one currency for xed-rate interest in another currency 4 Basis swaps Basis swaps represent a variation on interest-rate swap contracts where both rates are variable but tied to different index rates 5 Equity swaps Equity swaps occur when counterparties exchange cash ow streams tied to an equity index with a xed or oating interest 6 Commodity swaps Commodity swaps occur when counterparties exchange cash ow streams tied to the difference between a commodity s agreed upon price and its variable price, applied to an agreed-upon price of the commodity 7 Mortgage swaps Typical mortgage swaps occur when an investor exchanges interest payments tied to a short-term oating rate, for cash ows based an a generic class of mortgagebacked securities over a speci ed period The cash ows received by the investor include the xed coupon on the generic class or mortgage-backed securities and any discount or premium The notional amount of the mortgage swap is adjusted monthly, based on amortization and prepayment experience of the generic class of mortgage-backed securities When the contract expires, the investor may either have to take physical delivery of the mortgages (at a predetermined price) or settle in cash for the difference between the predetermined price and the current market value for the mortgages Collateral may be posted to reduce counterparty credit risk (v) Foreign Exchange Contracts These contracts are used both to provide a service to customers and as a part of the institution s trading or hedging activities The bank pro ts by maintaining a margin between the purchase price and sale price Contracts may be for current trades (spot contract), future dates (forward contract), or swap contracts The bank may also enter into these contracts to hedge a foreign currency exposure (vi) Other Variations Other types of derivative products are discussed in 26, Derivatives and Hedge Accounting (vii) Accounting Guidance The FASB issued Statement No 133, Accounting for Derivative Instruments and Hedging Activities, in June 1998 Statement No 133 provides a comprehensive and consistent standard for the recognition and measurement of derivatives and hedging activities
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The Statement resolves the inconsistencies that existed with respect to accounting for derivatives and changes considerably the way many derivatives transactions and hedged items are reported SFAS No 133 requires all derivatives to be recorded on the balance sheet at fair value and establishes special accounting for the following three different types of hedges: hedges of changes in the fair value of assets, liabilities, or rm commitments (referred to as fair value hedges); hedges of the variable cash ows of forecasted transactions (cash ow hedges); and hedges of foreign currency exposures of net investments in foreign operations The accounting treatment and criteria for each of the three types of hedges are unique Changes in fair value of derivatives that do not meet the criteria of one of these three categories of hedges are included in income The four basic underlying premises of the new approach are: 1 Derivatives represent rights or obligations that meet the de nitions of assets (future cash in ows due from another party) or liabilities (future cash out ows owed to another party) and should be reported in the nancial statements 2 Fair value is the most relevant measure for nancial instruments and the only relevant measure for derivatives Derivatives should be measured at fair value, and adjustments to the carrying amount of hedged items should re ect changes in their fair value (ie, gains and losses) attributable to the risk being hedged arising while the hedge is in effect 3 Only items that are assets or liabilities should be reported as such in the nancial statements (The Board believes gains and losses from hedging activities are not assets or liabilities and, therefore, should not be deferred) 4 Special accounting for items designated as being hedged should be provided only for qualifying transactions, and one aspect of quali cation should be an assessment of the expectation of the effectiveness of the hedge (ie, offsetting changes in fair values or cash ows) See 26 for further guidance on SFAS No 133 (y) FIDUCIARY SERVICES AND OTHER FEE INCOME (i) Fiduciary Services In their duciary capacity, banks must serve their clients interests and must act in good faith at a level absent in most other banking activities In view of this high degree of duciary responsibility, banks usually segregate the responsibilities of the trust department from that of the rest of the bank This segregation is designed to maintain a highly objective viewpoint in the duciary area Fiduciary services range from the simple safekeeping of valuables to the investment management of large pension funds Custodial, safekeeping, and safe deposit activities involve the receipt, storage, and issuance of receipts for a range of valuable assets This may involve the holding of bonds, stocks, and currency in escrow pending the performance under a contract, or merely the maintenance of a secure depository for valuables or title deeds As custodian, the bank may receive interest and dividends on securities for the account of customers Investment management may be discretionary, whereby the bank has certain de ned powers to make investments, or nondiscretionary, whereby the bank may only execute investment transactions based on customers instructions The former obviously involves a higher degree of risk to the institution and creates an obligation to make prudent investment decisions Other duciary services include trust administration, stock and bond registrar, and bank trustee Trust administration involves holding or management of property, such as pension funds and estates for the bene t of others Stock and bond registrar and bank trustee functions include the maintenance of records and execution of securities transactions, including changes in ownership and payment of dividends and interest Since the assets and liabilities of the trust department of the bank are held in an agency capacity, they are not recorded on the balance sheet of the bank These activities can, however, generate signi cant fee income, which is recorded when earned in the statement of income
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