Swaps Market, evolution, valuation THOMSON REUTERS Julien LORENZI, Adfin Analytics Quant team Manager 27th March 2014 Agenda for today A brief introduction Swap Market volume trends Swaps Definition and Conventions Swap Strategies Towards Collateralisation Pricing Swaps: Adapt to the new market reality Q&A OTC Derivatives Market Share Credit default swaps 4% Unallocated 4% Equity Options 1% Rate Options 7% Forwards and forex swaps 5% Currency swaps 4% FX Options 2% Forward rate agreements 12% Interest rate swaps 61% Source : bis.org Triennial Central Bank Survey of foreign exchange and derivatives market activity in 2013 Interest Rate Swap Currency Allocation BRL 1% CAD 2% AUD 5% SEK 1% CNY CHF KRW MXN NOK 1% 0% 1% 1% 0% Other currencies 2% JPY 4% GBP 7% EUR 49% USD 26% Source : bis.org Triennial Central Bank Survey of foreign exchange and derivatives market activity in 2013 Growth of the Interest Swap Market Notional Principal Outstanding ( trillon $ ) 500 450 400 350 300 250 200 150 100 50 0 Source Bis.org Semi Annual Statistical Annex June 2013 Single-currency interest rate derivatives Growth of the Cross Currency Swap Market Notional Principal Outstanding ( trillon $) 30 25 20 15 10 5 0 Source Bis.org Semi Annual Statistical Annex June 2013 Foreign Exchange Derivatives Agenda for today A brief introduction Swap Market volume trends Swaps Definition and Conventions Swap Strategies Towards Collateralisation Pricing Swaps: Adapt to the market reality Q&A DEFINITION: SWAPS A swap is: • An OTC Transaction • An agreement between 2 parties ( Leg1, Leg2) • to exchange a stream of cash flows against another stream of cash flows – – • At an agreed set of dates Cash flow of any types ( Fixed, Floating Rate, Index linked, ….) Generally based on : – – – – A notional on which are applied rates A formula or fixed rate to compute Leg 1 A formula or fixed rate to compute Leg 2 A start Date, a Maturity, a frequency Swap Documentation • Historically, since 1981 ISDA • Master Swap agreement – One agreement for all documents: • Credit Support Annex • Confirmation – Ensure that a new transaction cannot be settled in case of an actual default or potential default of one party – Closed-out Nettings – Credit Support Annex INTEREST RATE SWAPS Interest Rate Swap ( IRS) • • • • • • One leg is Fixed while the other one is floating Maturity is typically ranges from 1 year till 25 years The party who pays Fixed is the Fixed Rate Payer, the other one the Floating Rate Payer Notional remains constant during the life of IRS Floating Rate is generally fixed in Advance, paid in arrears Cash Flows are netted INTEREST RATE SWAPS CONVENTIONS • Ccy EUR USD JPY GBP CHF Different conventions will apply depending on the currency and ref Tenor for quotations Ref Libor Tenor 6M 3M 6M 6M 6M Fixed Leg 30/360 30/360 Act/365 Act/365 Act/365 annual annual s.a s.a s.a Floating Leg Act/360 Act/360 Act/360 Act/365 Act/365 Spot Lag s.a Quaterly s.a s.a s.a 2 2 2 0 2 EXAMPLE: IRS 5Y Fixed Rate Payer 1.0477% 2bd 1y 1y 1y 1y 1y Maturity Trade Date Start Date Netted Euribor 1Y Floating Rate Payer CROSS CURRENCY SWAP DEFINITION • Same concept than Interest rate swap but it differs by the fact that: • Interest payment of leg 1 are based on one NOTIONAL • Interest payment of leg 2 are based on another NOTIONAL • Exchange of principal at inception & maturity executed at FX Spot rate • Legs can be Fixed/Fixed, Fixed/Floating, Floating/Floating ( in latter case we call it Cross Currency Basis swaps) EXAMPLE: Cross Currency Basis Swap EUR/USD BANKS ROLE • A swap bank is a generic term to describe a financial institution that facilitates swaps between counterparties. • The swap bank can serve as either a broker or a dealer. – As a broker, the swap bank matches counterparties but does not assume any of the risks of the swap. – As a dealer, the swap bank stands ready to accept either side of a swap, and then later lay off their risk, or match it with a counterparty. Agenda for today A brief introduction Swap Market volume trends Swaps Definition and Conventions Swap Strategies Towards Collateralisation Pricing Swaps: Adapt to the market reality Q&A SWAPS STRAGEGIES • Tailor the stream profile of cash flows • ALM: Manage profile of liabilities. Reduce/Increase duration • Reduce financing costs ( taking advantage from comparative advantage) • Speculation • Hedging An Example of an Interest Rate Swap The swap bank makes 50bp Swap IRS Deal 1 Euribor IRS Deal 2 Euribor Bank 4% 4.5% Company A Wants Floating Company A pays Euribor + 100 bp Company B pays 7.5% => saves 50 bp => saves 50 bp Company B Wants Fixed 5% Euribor + 300 bp Bank A Bank B Company A Fixed Rate Loan Floating Rate Loan Company B 5% Euribor + 150 bp Difference A vs B 8% Euribor + 300 bp 3% 1,50% Example of an Cross Currency Swap 1/3 (inception) Cross Ccy Deal 1 Cross Ccy Deal 2 Swap 12m principal EUR 12m principal EUR Bank 10m principal GBP 10m principal GBP German Corporate English Corporate Need raise GBP Need raise USD 12m principal EUR 10m principal GBP German Bank English Bank Exchange rate 1 GBP = 1.2 EUR Fixed Rate Loan EUR Fixed Rate Loan GBP German corporate English Corporate 5% 7% 7.5% 8% Difference English/German 2% 0.5% An Example of an Cross Currency Swap 2/3 (Interests ) Gain 1% GBP & 1.5% EUR ! Cross Ccy Deal 1 Cross Ccy Deal 2 Swap 7% GBP 8% GBP Bank 5% EUR 6.5% EUR German Corporate Need GBP Gain 50 bp GBP Gain 50 bp EUR 5% EUR English Corporate Need EUR 8% GBP German Bank Exchange rate 1 GBP = 1.2 EUR Fixed Rate Loan EUR Fixed Rate Loan GBP English Bank Difference German corporate English Corporate English/German 5% 7% 7.5% 8% 2% 0.5% Example of a Cross Currency Swap 3/3 (Maturity) Cross Ccy Deal 1 Cross Ccy Deal 2 Swap 12m principal EUR 12m principal EUR Bank 10m principal GBP 10m principal GBP German Corporate English Corporate Need GBP Need USD 12m principal EUR 10m principal GBP German Bank English Bank Exchange rate 1 GBP = 1.2 EUR Fixed Rate Loan EUR Fixed Rate Loan GBP German corporate English Corporate 5% 7% 7.5% 8% Difference English/German 2% 0.5% QUICK REMINDER: EONIA vs EURIBOR Euro Interbank Offered Rate Euro Overnight Index Average • • Maturity = Overnight Calculated based upon the assets created overnight by the interbanks. • • • Maturity = from 1W to 1Y Calculated by eliminated 15% of the highest and lowest quotes collected. The rates include a spread that compensates the counterparty risk. EURIBOR is criticized because of its calculation method => it is not anymore a reference for risk free rates Overnight Index Swap (OIS) • The floating leg is indexed on an overnight rate (Ex: EONIA) • OIS maturities generally go from 1W to 1Y. 2% SWAP • An indicator for the credit market’s health. EONIA If EONIA is<2%, A will pay the difference to B If EONIA is>2%, B will pay the difference to A Floating EONIA Fixed 2% Other types of swaps: • Basis Swaps or Tenor Swaps – Receive floating + a spread ( ex: EURIBOR3M + spread) on a quarterly basis – Pay EURIBOR6M on semi-annually basis in same ccy • Amortizing swap: – Principal decreases with time => Hedge mortgage • Accreting Swap • Inflation swaps => Hedge inflation • CMS Swap, CMS spread Swap Main Risks of swaps: • • • • • Interest Rate Risk Basis Risk FX Risk Exchange Rate Risk for Cross Currency Swaps Credit Risk: – Depends on probability of default and evolution of market – When is the most risky moment for an IRS? – For a cross currency swap? How to mitigate Credit Risk: • Using Credit Default Swap but there may be no market for CDS, no good proxy Solutions to mitigate market: • Collateralisation • Recognition of counterparty risk in a OTC transaction : CVA ( counterparty value Adjustment) T CVA = (1− R) ∫ dP(t) eˆ∗(t) 0 Agenda for today A brief introduction Swap Market volume trends Swaps Definition and Conventions Swap Strategies Towards Collateralisation Pricing Swaps: Adapt to the market reality Q&A What is collateralisation? Type of collateralisation collateralisation Financial Instruments Regulated Market OTC Markets All trades are collateralised variable depending on the agreements between parties Highly standardized Highly Customized There is a Clearing House that stands in the middle of the transactions for any trade. Provide the rules for No Clearing House. marginning and settlement Direct management between parties Clearing House margination frequency Collateral type daily Cash or high rates bonds Depends on contract Depends but usually cash Collateral rate eonia rate Depends Market Regulation • Since Crisis in 2007/2008, regulation is changing quickly to improve transparency and mitigate credit risk • US in 2011, Dodd Franck Act => regulate market to prevent new crisis – CFTC ( commodity futures commission) has added new rules: – Most OTC transactions must be centrally cleared – Transaction are done through SEF ( Swap execution facility) • which needs to store deals in SDRs ( Swap Data repositories) Europe: EMIR ( European Market Infrastructure Regulation) in globally on the same page but there are differences of applications to what must be collateralized and which actors should collateralize their transactions SEF Market Regulation • Basel 3, CVA capital charges have increased significantly which requires more capital to hedge CVA => incentive to move to collateralisation Collateralisation in figures • ISDA Margin survey June 2013: – Among all firms responding to the survey, 73.7 percent of all OTC derivatives trades (cleared and non-cleared) are subject to collateral agreements. For large firms, the figure is 80.7 percent. – Responding firms also reported that 69.1 percent of all noncleared trades are subject to collateral agreements. For large firms, the figure is 75.3 percent Agenda for today A brief introduction Swap Market volume trends Swaps Definition and Conventions Swap Strategies Towards Collateralisation Pricing Swaps: Adapt to the market reality Q&A Swap Valuation • For most cases ( IRS, Basis Swaps, Cross Currency Swaps), closed formula are sufficient: n m i =1 j =1 SwapNPV = ∑ E Q (Fwdi ) × yfi × DFt i − RFixed ∑ yf j × DFt j E Q (Fwd i ) = 1 DFi −1 ( − 1) yfi DFi • • Convexity adjustment for Evaluation of Fwd Rate if implied deposit dates <> Period Dates Swap Valuation • Eventually, most important when pricing swaps – Use right curve for each leg – Need accurate bootstrapping process for curves to price accurately all instrument of the market – Use the “right” discount curve. – Need to generate different curves Before 2007 financial crisis Interchangeability between: • Discount curve: curve used to discount cash flows. • Forward Curve: Curve an estimation of the future libor rates • Assumption: Libor is the risk free curve, there is no basis swaps…… Pricing Swaps: Before 2007 PRICING A SWAP: Bootstrapping Step 1: Deposits Step 2: including FRAs PRICING A SWAP: Bootstrapping Step 3: Swaps 2007 financial crisis impact Before FC, OIS and Libor were more or less assumed to be interchangeable (source: Thomson Reuters) 2007 financial crisis impact Before FC, Spread between different Tenor-Libor were relatively low Historical basis swaps USD 3M Libors vs 6M Libors, 1-Year maturity (source: Thomson Reuters) 1M 15-août-13 16-août-13 28-août-13 14-sept.-13 14-nov.-13 14-févr.-14 14-août-14 14-févr.-15 14-août-15 14-août-16 14-août-17 14-août-18 14-févr.-21 14-août-23 14-févr.-26 14-août-28 14-févr.-31 14-août-33 14-févr.-36 14-août-38 14-févr.-41 14-août-43 14-févr.-46 14-août-48 14-févr.-51 14-août-53 14-févr.-56 14-août-58 14-févr.-61 14-août-63 Market Segmentation 3,00% 2,50% 2,00% 1,50% 1,00% 0,50% 0,00% Rate Surface for Euro Source: Adfin Implications of the crisis – CCR mitigation (most popular) : collateral posting, netting (portfolio) – IR Market segmentation: Depending on underlying Libor Tenors for a given instrument, different forward curve must be used – What is the funding curve (discount curve) ? OIS curve for swaps under CSA (collateralized swaps) Use the right Forward Curve when pricing Collateral Impact Structure of Swap Market standard quoted instruments For each currency, there is a reference Swap Market where the instruments are the most traded & liquid Ex: • 6M ( Swaps fixed vs Semi Annualy Floating ) for EUR • 3M ( Swaps fixed vs Quaterly Floating ) for USD For other Tenors, need to take into account Basis Swaps which are typically quoted against Reference Market How to take into account Basis Swaps? Inputs – OIS curve – Deposits, Fra/Futures, Swaps D, F, IRS(3M), Basis Swaps(3M vs 6M) Basis Swaps (6M vs1Y) and Basis Swaps (1M vs 3M) – Build 3M Forward Curve such that can replicate market quotes for IRS6M & Basis Swaps ( 3M,.6M) – Build 1M Forward Curve such that can replicate market quotes for IRS6M & Basis Swaps ( 3M,.6M) & Basis Swaps ( 1M,3M) simultanously Single Currency: Curve generation Exact solution: solve all rate simultaneously, but could a too high dimension problem successive lower multi-dimension solving Libor curve dependencies Single Currency: Curve generation • USD 3M Libor forward curve: Built using: Standard swaps with 3M underlying tenor Discount curve ∑ i Fwd 3 M $ i × yf i × DF $ i = R$ × ∑ yf i × DF $ i i 50 Single Currency: Curve generation • USD 6M Libor forward curve: Built using: USD 3M/6M Libors basis swaps USD 3M Libor Forward Curve Discount curve ∑ i Fwd 6 M $ i × yf i × DF $ i = ∑ (Fwd 3M $ i + S 3M /6M )× yf i × DF $ i i 51 ASSUMPTIONS Hypotheses we are making: Full collateralization ( no threshold, no MTA ) Bilateral collateralization Continuous collateral settlement Same collateral rate for both counterparties Collateral currency = pay off currency Cash collateral In such a way the CCR and liquidity risk can be neglected Requirements: Build the OIS discount curve and the interest generation curve the that the market calibrating instruments are repriced HOW TO TACKLE THIS IN EIKON? Several phases: – Library level ( Quantitative Analyst) • Review of the financial litterature about multi curve/ OIS discounting topics • Review of the implication in our pricing • Proposal of a new algorithm framework in collaboration with external and internal clients • Implementation of the code in the library • Validation against market Data using Excel – Realtime data level: • Using the new algorithm, change the pages to provide improved curves – Financial Calculators level: • Adapt the screen to new model • Implementation against the library • Validation against Market Next Steps • Single currency case: – is there a need to take into account collateral daily margining instead of continuous ? How? By CVA/DVA ?One-way collateral arrangements. – What about partial collateralization ? • Additional features will be added such as: – Funding cost (LVA). – One-way collateral arrangements. – Margining thresholds on collateral placement. – Collateral placing at wider time intervals (e.g. monthly). (Credit Risk Adjustment (CVA) will be added when collateralization does not fully eliminate credit risk) Agenda for today A brief introduction Swap Market volume trends Swaps Definition and Conventions Swap Strategies Towards Collateralisation Pricing Swaps: Adapt to the market reality Q&A
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