The global capital markets have considerably increased their use of derivatives over the last twenty years or so. It is the flexibility of derivative instruments, which can be created to allow for almost any financial activity or credit risk, that has helped to make them so popular. Derivatives come in many forms: swaps, forward rate agreements, futures, credit default swaps, options and many combinations of the above such as swaptions.
The swap market over recent years has grown considerably, with the result that it is now very large and very flexible. According to a survey, conducted by the Bank for International Settlements (BIS),1 of the OTC (over-the-counter) derivatives market activity in the second half of 2004, the notional amounts outstanding at the end of December 2004 of interest rate contracts amounted to some $187 trillion with a gross market value of $5.3 trillion. Of these, the majority were interest rate swaps (see Figure 9.1).
Interest rate OTC contracts tend to have a much longer life than repos, which frequently have an initial maturity of under one month. Of the outstanding OTC interest rate contracts, over 25 % of them had an outstanding life to maturity of over five years and about two-thirds over one year (see Figure 9.2). Similarly, the most popular currency is now the euro, where the activity represents 8.4 % more of the total activity than the US dollar (see Figure 9.3).
The majority of swaps include synthetic ...