The Ethics of Banking: Conclusions from the Financial Crisis (Issues ...

88 6 The Ethical Economy of the Market for Derivatives
is just a series of forward contracts that are tied together in a sequence. The contract
obliges the two contracting parties to exchange payment streams.
Interest Rate Swaps
Imagine a firm that has agreed a variable interest rate for its borrowing.
Nevertheless, it would like more certainty about its future interest payments and
therefore wants to lock in a constant interest rate for a particular period of time. In
a swap contract, it makes a deal with another firm or a bank which, in exchange
for payment of a one-off fee and constant monthly interest at rate R, offers to pay
the variable interest rate R ∗ on every due date. The variable interest rate payments
R ∗ falling due on future dates t + n, expressed as Rt ∗ for (t = 1...n), are replaced
by the constant interest payments R, expressed as Rt for t = 1...n, and a forwardcontract
fee. The swap represents a sequence of forward contracts F, for F = Fa ∗ and
a ∗ = 1...n, which have been individually negotiated and tied together into a single
swap contract. 8
Credit-Default Swaps
In a credit-default swap, the swap seller or protection seller, usually a bank, enters
into an obligation in exchange for a fee paid by the swap buyer or protection buyer,
which is a finance company or an investor, that if the firm that issued the reference
bond fails to make interest payments, the swap seller will make interest payments
to the swap buyer, or if the bond issuer becomes insolvent, i.e. in the event of credit
default, it will repay the loan in full. Again, the main motives for credit-default
swaps are hedging by the lender and swap buyer in parallel with speculation by
the swap buyer and/or the swap seller. The credit-default swap is equivalent to a
credit insurance policy in that it insures the protection buyer against default by the
reference debtor, whose debt is the underlying value of the credit-default swap. 9
At the same time, however, there are important differences between the creditdefault
swap and credit insurance, which typify the problematic side of derivatives.
The buyer of the credit-default swap, the protection buyer, needs not own the reference
value, which can be identical with the underlying security but may differ from
it; he need not even be exposed to loss by the reference value but can hold the creditdefault
swap for purely speculative reasons. The protection seller, the seller of the
swap, need not be a legally regulated entity or hold any reserves in order to pay out
to the protection buyer. Unlike insurance companies, which manage risks through
8 Cf. also DONALD H. CHEW JR.: The New Corporate Finance. Where Theory Meets Practice,
Boston (Irwin McGraw-Hill) 1999, pp. 468f.
9 Cf. also GERALD BRAUNBERGER: “Credit Default Swaps. Das Produkt, das die Finanzkrise
verschärfte” [The product that intensified the financial crisis], Frankfurter Allgemeine Zeitung,
3rd April 2009, No. 79, p. 24.