Post on 10-Jun-2018
Swaps Market, evolution, valuation
THOMSON REUTERSTHOMSON REUTERSJulien LORENZI, Adfin Analytics Quant team Manager
27th March 2014
Agenda for today
A brief introduction
Swap Market volume trends Swaps Definition and Conventions Swaps Definition and Conventions
Swap StrategiesSwap Strategies
Pricing Swaps:
Adapt to the new market reality
Pricing Swaps:
Adapt to the new market reality
Towards CollateralisationTowards Collateralisation
Q & AQ & A
Forwards and
forex swaps
5%Currency swaps
4%
FX Options
2%
Forward rate
agreements
12%
Rate Options
7%
Equity Options
1%
Credit default swaps
4%Unallocated
4%
OTC Derivatives Market Share
Interest rate swaps
61%
Source : bis.org Triennial Central Bank Survey of foreign exchange and derivatives market activity in 2013Source : bis.org Triennial Central Bank Survey of foreign exchange and derivatives market activity in 2013Source : bis.org Triennial Central Bank Survey of foreign exchange and derivatives market activity in 2013Source : bis.org Triennial Central Bank Survey of foreign exchange and derivatives market activity in 2013
EUR
49%
GBP
7%
AUD
5%JPY
4%
SEK
1%
CAD
2%
BRL
1%
CNY
1%
CHF
0%KRW
1%
MXN
1%
NOK
0% Other currencies
2%
Interest Rate Swap Currency Allocation
USD
26%
Source : bis.org Triennial Central Bank Survey of foreign exchange and derivatives market activity in 2013Source : bis.org Triennial Central Bank Survey of foreign exchange and derivatives market activity in 2013Source : bis.org Triennial Central Bank Survey of foreign exchange and derivatives market activity in 2013Source : bis.org Triennial Central Bank Survey of foreign exchange and derivatives market activity in 2013
Growth of the Interest Swap Market
300
350
400
450
500
Notional Principal Outstanding ( trillon $ )
0
50
100
150
200
250
Source Bis.org Semi Annual Statistical Annex June 2013 Single-currency interest rate derivatives
Growth of the Cross Currency Swap Market
25
30
Notional Principal Outstanding ( trillon $)
0
5
10
15
20
Source Bis.org Semi Annual Statistical Annex June 2013 Foreign Exchange Derivatives
Agenda for today
A brief introduction
Swap Market volume trendsSwap Market volume trends Swaps Definition and Conventions
Swap StrategiesSwap Strategies
Pricing Swaps:
Adapt to the market reality
Pricing Swaps:
Adapt to the market reality
Towards CollateralisationTowards Collateralisation
Q & AQ & 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• 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• 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 FixedFixedFixedFixed Rate Payer, Rate Payer, Rate Payer, Rate Payer, the other one the • The party who pays Fixed is the FixedFixedFixedFixed Rate Payer, Rate Payer, Rate Payer, Rate Payer, the other one the FloatingFloatingFloatingFloating Rate PayerRate PayerRate PayerRate 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
• Different conventions will apply depending on the currency and ref Tenorfor quotations
Ccy Ref Libor Tenor Fixed Leg
Floating
Leg Spot Lag
EUR 6M 30/360 annual Act/360 s.a 2EUR 6M 30/360 annual Act/360 s.a 2
USD 3M 30/360 annual Act/360 Quaterly 2
JPY 6M Act/365 s.a Act/360 s.a 2
GBP 6M Act/365 s.a Act/365 s.a 0
CHF 6M Act/365 s.a Act/365 s.a 2
EXAMPLE: IRS 5Y
2bd 1 y 1 y 1 y 1 y 1 y
1.0477%
Maturity
Fixed Rate Payer
Trade Date Start Date
Euribor 1Y
Maturity
Floating Rate Payer
Netted
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 NOTIONALInterest 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.• 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 trendsSwap Market volume trends Swaps Definition and Conventions Swaps Definition and Conventions
Swap Strategies
Pricing Swaps:
Adapt to the market reality
Pricing Swaps:
Adapt to the market reality
Towards CollateralisationTowards Collateralisation
Q & AQ & A
SWAPS STRAGEGIES
• Tailor the stream profile of cash flows
• ALM: Manage profile of liabilities. Reduce/Increase
duration
• Reduce financing costs ( taking advantage from • Reduce financing costs ( taking advantage from
comparative advantage)
• Speculation
• Hedging
An Example of an Interest Rate Swap
Swap
Bank
Company BCompany A Company B pays Company B pays Company B pays Company B pays
The swap bank The swap bank The swap bank The swap bank makes 50bpmakes 50bpmakes 50bpmakes 50bp
4.5%
EuriborEuribor 4%
Company A pays Company A pays Company A pays Company A pays
IRS Deal 1 IRS Deal 2
Company B
Wants Fixed
Company A
Wants Floating
Company B pays Company B pays Company B pays Company B pays
7.5% 7.5% 7.5% 7.5%
=> saves 50 => saves 50 => saves 50 => saves 50 bpbpbpbp
Company A Company B Difference A vs B
Fixed Rate Loan 5% 8% 3%
Floating Rate Loan Euribor + 150 bp Euribor + 300 bp 1,50%
Bank A Bank B
Euribor + 300 bp5%
Company A pays Company A pays Company A pays Company A pays
EuriborEuriborEuriborEuribor + 100 + 100 + 100 + 100 bpbpbpbp
=> saves 50 => saves 50 => saves 50 => saves 50 bpbpbpbp
Example of an Cross Currency Swap 1/3 (inception)
Swap
Bank
English CorporateGerman Corporate
Cross Ccy Deal 1 Cross Ccy Deal 2
10m principal GBP10m principal GBP
12m principal EUR12m principal EUR
English Corporate
Need raise USD
German Corporate
Need raise GBP
German Bank English BankExchange rate 1 GBP = 1.2 EUR
10m principal GBP12m principal EUR
German corporate English Corporate
Difference
English/German
Fixed Rate Loan EUR 5% 7% 2%
Fixed Rate Loan GBP 7.5% 8% 0.5%
An Example of an Cross Currency Swap 2/3 (Interests )
Swap
Bank
English CorporateGerman Corporate
Cross Ccy Deal 1 Cross Ccy Deal 2
6.5% EUR5% EUR
7% GBP8% GBP
Gain 1% GBP & 1.5% EUR !
English Corporate
Need EUR
German Corporate
Need GBP
German corporate English Corporate
Difference
English/German
Fixed Rate Loan EUR 5% 7% 2%
Fixed Rate Loan GBP 7.5% 8% 0.5%
German Bank English BankExchange rate 1 GBP = 1.2 EUR
8% GBP5% EUR
Gain 50 bp GBP Gain 50 bp EUR
Example of a Cross Currency Swap 3/3 (Maturity)
Swap
Bank
English CorporateGerman Corporate
Cross Ccy Deal 1 Cross Ccy Deal 2
10m principal GBP10m principal GBP
12m principal EUR12m principal EUR
English Corporate
Need USD
German Corporate
Need GBP
German Bank English BankExchange rate 1 GBP = 1.2 EUR
10m principal GBP12m principal EUR
German corporate English Corporate
Difference
English/German
Fixed Rate Loan EUR 5% 7% 2%
Fixed Rate Loan GBP 7.5% 8% 0.5%
QUICK REMINDER: EONIA vs EURIBOR
Euro Overnight Index AverageEuro Overnight Index AverageEuro Overnight Index AverageEuro Overnight Index Average Euro Interbank Offered RateEuro Interbank Offered RateEuro Interbank Offered RateEuro Interbank Offered RateEuro Overnight Index AverageEuro Overnight Index AverageEuro Overnight Index AverageEuro Overnight Index Average
• Maturity = Overnight
• Calculated based upon the assets
created overnight by the interbanks.
Euro Interbank Offered RateEuro Interbank Offered RateEuro Interbank Offered RateEuro Interbank Offered Rate• Maturity = from 1W to 1Y
• Calculated by eliminated 15% of the highest and lowest quotes collected.
• The rates include a spread thatcompensates 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
Floating
EONIA
Fixed
2%
EONIA
2%
SWAP
If EONIA is<2%, A will pay the difference to B
If EONIA is>2%, B will pay the difference to A
• OIS maturities generally go
from 1W to 1Y.
• An indicator for the credit
market’s health.
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:• 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• 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• Collateralisation
• Recognition of counterparty risk in a OTC transaction : CVA ( counterparty value Adjustment)
0
ˆCVA (1 ) ( ) ( )T
R dP t e t∗
= − ∫
Agenda for today
A brief introduction
Swap Market volume trendsSwap Market volume trends Swaps Definition and Conventions Swaps Definition and Conventions
Swap StrategiesSwap Strategies
Pricing Swaps:
Adapt to the market reality
Pricing Swaps:
Adapt to the market reality
Towards Collateralisation
Q & AQ & A
What is collateralisation?
Type of collateralisation
Regulated Market OTC Markets
collateralisation All trades are collateralised
variable depending on the agreements
between parties
Financial
Instruments Highly standardized Highly CustomizedInstruments Highly standardized Highly Customized
Clearing House
There is a Clearing House that stands
in the middle of the transactions for
any trade. Provide the rules for
marginning and settlement
No Clearing House.
Direct management between parties
margination
frequency daily Depends on contract
Collateral type Cash or high rates bonds 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– 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. percent.
– Responding firms also reported that 69.1 percent of all non-
cleared trades are subject to collateral agreements. For large
firms, the figure is 75.3 percent
Agenda for today
A brief introduction
Swap Market volume trendsSwap Market volume trends Swaps Definition and Conventions Swaps Definition and Conventions
Swap StrategiesSwap Strategies
Pricing Swaps:
Adapt to the market reality
Towards CollateralisationTowards Collateralisation
Q & AQ & A
Swap Valuation
• For most cases ( IRS, Basis Swaps, Cross Currency Swaps), closed formula are sufficient:
∑∑ ×−××=m
Fixed
n
R tjtiiQ DFyfDFyf)(FwdESwapNPV
•
• Convexity adjustment for Evaluation of Fwd Rate if implied deposit dates <> Period Dates
∑∑==
×−××=j
Fixed
i
R1
tj
1
tiiQ jiDFyfDFyf)(FwdESwapNPV
)1(yf
1 )(FwdE 1
i
iQ −= −
i
i
DF
DF
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 marketprice accurately all instrument of the market
– Use the “right” discount curve.
– Need to generate different curves
Before 2007 financial crisisInterchangeability between:
• Discount curveDiscount curveDiscount curveDiscount curve: used to discount cash flows.
• Forward CurveForward CurveForward CurveForward Curve: an estimation of the future libor rates• Forward CurveForward CurveForward CurveForward 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: BootstrappingBootstrappingBootstrappingBootstrapping
Step 1: Deposits
Step 2: including FRAs
PRICING A SWAP: BootstrappingBootstrappingBootstrappingBootstrapping
Step 3: Swaps
2007 financial crisis impactBefore FC, OIS and Libor were more or less assumed to be interchangeable
(source: Thomson Reuters)
2007 financial crisis impactBefore FC, Spread between different Tenor-Libor were relatively low
Historical basis swaps USD 3M Libors vs 6M Libors, 1-Year maturity (source: Thomson Reuters)
Market Segmentation
0,50%
1,00%
1,50%
2,00%
2,50%
3,00%
1M
0,00%
0,50%
15
-ao
ût-
13
16
-ao
ût-
13
28
-ao
ût-
13
14
-se
pt.
-13
14
-no
v.-1
31
4-f
évr
.-1
41
4-a
oû
t-1
41
4-f
évr
.-1
51
4-a
oû
t-1
51
4-a
oû
t-1
61
4-a
oû
t-1
71
4-a
oû
t-1
81
4-f
évr
.-2
11
4-a
oû
t-2
31
4-f
évr
.-2
61
4-a
oû
t-2
81
4-f
évr
.-3
11
4-a
oû
t-3
31
4-f
évr
.-3
61
4-a
oû
t-3
81
4-f
évr
.-4
11
4-a
oû
t-4
31
4-f
évr
.-4
61
4-a
oû
t-4
81
4-f
évr
.-5
11
4-a
oû
t-5
31
4-f
évr
.-5
61
4-a
oû
t-5
81
4-f
évr
.-6
11
4-a
oû
t-6
3
Rate Surface for Euro Source: Adfin
Implications of the crisis
– CCR mitigation (most popular) : collateralcollateralcollateralcollateral 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: 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 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 generationExact 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
ii
i
iii DFyfRDFyfMFwd $$$$3
50
Single Currency: Curve generation
• USD 6M Libor forward curve:
� Built using:
� USD 3M/6M Libors basis swaps
� USD 3M Libor Forward Curve
� Discount curve
51
� Discount curve
( )∑∑ ××+=××i
iiMMi
i
iii DFyfSMFwdDFyfMFwd $
6/3
$$$ 36
ASSUMPTIONSHypotheses we are making:Hypotheses we are making:Hypotheses we are making: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 currencyCollateral currency = pay off currency
Cash collateral
In such a way the CCR and liquidity risk can be neglected
RequirementsRequirementsRequirementsRequirements::::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 internalclientsclients
• 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:• 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 trendsSwap Market volume trends Swaps Definition and Conventions Swaps Definition and Conventions
Swap StrategiesSwap Strategies
Pricing Swaps:
Adapt to the market reality
Pricing Swaps:
Adapt to the market reality
Towards CollateralisationTowards Collateralisation
Q & A