A. The decision by the U.S. Treasury to pay down the national debt has reduced the supply of treasury bonds, which in the past has been the valuation benchmark for fixed income instruments. As treasury bonds vanished, so did the correlation to other fixed income product. The industry could have turned to debt issued by government sponsored enterprises like Fannie Mae, but political ramifications left questions surrounding the government backing of the securities. Given that Libor has been the global benchmark for floating debt since the early 1990's, and size of the swap market ($50 trillion in contracts outstanding), it appears the swap curve is the ideal benchmark for fixed income products.

Q. What is an interest rate swap?

A. An interest rate swap is effectively a portfolio of forward contracts where two parties (generally called counterparties) agree to exchange to interest payments. The most common type of swap is when one party agrees to pay fixed interest payments at designated dates for the life of the contract (this party would be referred to as the fixed-rate payer). The other party agrees to make interest payments that float with Libor (referred to as the floating-rate payer). The interest payments exchanged are based off a predetermined dollar(or other currency) amount. This amount is referred to as the notional principal amount.

Q. What is a synthetic interest rate swap?

A. As mentioned above, a swap is a portfolio of forward contracts where interest payments are exchanged between two parties. The 3-month Libor futures contract(officially called the Eurodollar contract), which is traded on the Chicago Mercantile Exchange, is by definition a cash-settled future underlied by an agreement to pay or receive a cash settlement based on three month Libor rate once the contract has expired.. The contract size (notional amount) is $1,000,000. There are 40 contracts that expire every 3 months. This series of short-term interest rate contracts with successive expiration dates can be put together and effectively create a swap.

Q. Why would I want to use a synthetic swap over a traditional swap agreement?

A. COST SAVINGS! By using an exchange-traded product, the counterparty credit risk is virtually eliminated. If your company does not enjoy a particularly high credit rating, your swap agreement is priced accordingly. Since futures are marked-to-market, there is little chance of a credit default and the exchange members share the responsibility of any debt obligations. Also there is a premium for passive management. Swap agreements are generally customized to a clients needs (i.e.amortizing swaps) and there is a cost associated with this customization. When you create a swap using 3 month LIBOR futures, you do the customizing yourself.

Q. How do I make a synthetic swap?

A. Call us. We will give you user-friendly software that enables you to build your own swap. If you are willing to take some time, we will walk you through the process step by step. If you don't have the time, we will do it for you.