Interest and equity swaps do not involve initial and final payments of principal or notional value, although the counter-party with the greater credit risk may have to deliver some collateral. Currency and foreign exchange swaps do require initial and final delivery of principal. A foreign exchange swap, generally a very short term deal, is a combination of a spot sale of currency and a forward purchase—it packages in a single deal both foreign exchange market legs of the familiar interest rate parity arbitrage operation. Foreign exchange swaps coupled with spot exchange sales are the standard wholesale market technique for establishing forward currency positions.
A currency swap similarly requires an initial and final exchange of principal amounts of the two currencies at predetermined forward exchange rates, but it is of longer maturity and involves periodic exchanges of interest on the principal amounts in the two currencies. A currency swap can be interpreted as a bundle of forward exchange contracts with sequentially lengthening maturities.
A structured note requires the delivery of a given amount of principal by the buyer to the seller, as in a standard bond purchase. The payoff of either interest or principal is set as a function of some underlying market value, such as an exchange rate or interest rate. Depending on the nature of the formula, the payoff may deliver multiples of the initial principal; or, on the downside, the principal may be wiped out.
Data on the Extent of Derivative Markets
The 1995 BIS survey of market participants in the major and many minor financial centers indicated that the notional value of over-the-counter (OTC) derivative products outstanding was $47.5 trillion in March 1995, and of this about 55% were cross-border transactions.2 3 Most of this amount consisted of simple interest rate products such as swaps, and most cross-border transactions occurred between industrial countries.4 For other derivative products, there are, nevertheless, large notional values outstanding in absolute terms—equity based products and structured notes and options which may be quite complex—and these are also used to an ever-expanding extent in key emerging market countries.