Henry wonder if this is accurate?
Posted by Bryan on Sunday, 6 September 1998, at 11:19 p.m.
(C) The Prudent Bear
For Private Use Only
Today, under the Federal Reserve margin rules, stock buyers can borrow only 50% of the value of the share they buy. In 1929, they could borrow up to 78%. A plain vanilla equiy swap involves a notional principal, a specified tenor, preset payment intervals, a fixed rate(the swap coupon), and a floating rate pegged to some well defined index. The floating rate is based on the total return of a stock index(such as the S&P 500, the DJIA, the Russell 2000, etc.) Alternatively, the swap may be pegged to a sector(semiconductor, networking, computer box maker). Suppose an institution wants to receive the index return and pay the fixed rate. The payments are to made each quarter on a notional principal of $50 million. The tenor is one year. The swap dealer(like Bankers Trust) prices the swap at 10%qr(a periodic rate of 2.5%) The swap is written so that the notional principal is constant over the life of the swap. The institution has $50 million in exposure to the index on what technically amounts to 10% margin. In other words, equity swaps allow the institution to borrow 90% of the value of the index they are purchasing! Higher than 1929! And Alex Rivlin said she wasn't sure this market was running on credit!
By the way, there is no national clearinghouse for swaps like there are for futures and options. Swap Dealers are on their own with regards to default risk and credit risk.
Thanks Henry.
For those of you interested in an ongoing discussion of derivatives other than this site the url is:
prudentbear.com
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