Get Smarter About Using Interest Rate Derivatives · Get Smarter About Using Interest Rate...
Transcript of Get Smarter About Using Interest Rate Derivatives · Get Smarter About Using Interest Rate...
Get Smarter About Using Get Smarter About Using Interest Rate DerivativesInterest Rate Derivatives
Elaine PhilbrickElaine PhilbrickRob PrattRob Pratt
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About the speakersAbout the speakers
Elaine Philbrick has 15 years of experience in the derivatives Elaine Philbrick has 15 years of experience in the derivatives industry. She is formerly a Director with Fleet Bank and industry. She is formerly a Director with Fleet Bank and established Fleet Bankestablished Fleet Bank’’s derivatives sales group in the early s derivatives sales group in the early ’’90s. She has an MBA from Boston University and a BA from 90s. She has an MBA from Boston University and a BA from Colby College.Colby College.
Rob Pratt has 20 years of banking experience, and started the Rob Pratt has 20 years of banking experience, and started the first small business derivative sales effort in the country whilfirst small business derivative sales effort in the country while e at Fleet Bank. Prior to joining Fleet he was the Funding at Fleet Bank. Prior to joining Fleet he was the Funding Manager and derivatives trader for the Federal Home Loan Manager and derivatives trader for the Federal Home Loan Bank of Boston where he managed the $200 billion derivative Bank of Boston where he managed the $200 billion derivative portfolio. He has a BA from St. Michaelportfolio. He has a BA from St. Michael’’s College and an MBA s College and an MBA from Boston College.from Boston College.
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What are interest rate What are interest rate derivatives?derivatives?
Definition: Definition: An agreement to exchange interest An agreement to exchange interest payments based on a market index.payments based on a market index.
Examples:Examples:SwapCap
Collar
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Interest Rate Swap
A borrower enters into a loan agreement to A borrower enters into a loan agreement to borrow based on a floating rate, and enters borrow based on a floating rate, and enters
into a swap agreement to fix the rate.into a swap agreement to fix the rate.
Two steps to a fixed rate:Two steps to a fixed rate:
Borrower
Loan
LIBOR + Loan Spread
Finance Provider
Fixed Rate
LIBOR + Loan Spread
Borrower
Swap
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Interest Rate SwapInterest Rate Swap
4.4%
4.6%
4.8%
5.0%
5.2%
5.4%
Swap
Futures
Swap rate is the Swap rate is the weighted average of weighted average of the Eurodollar futures the Eurodollar futures setssets
No upfront feesNo upfront fees
Potential prepayment Potential prepayment costcost
Requires credit Requires credit approvalapproval
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4%
5%
6%
7%
8%
9%
10%
Puts maximum Puts maximum rate on variable rate on variable rate loansrate loans
Upfront feeUpfront fee
No prepayment No prepayment costcost
Does not require Does not require credit approvalcredit approval
LIBOR
Cap
Interest Rate CapInterest Rate Cap
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Interest Rate CollarInterest Rate Collar
2%
3%
4%
5%
6%
7%
8%
Cap
LIBOR
Puts maximum (Cap) Puts maximum (Cap) and minimum (Floor) and minimum (Floor) rate on variable rate rate on variable rate loansloans
• Often structured with no upfront fees
• Potential prepayment cost
• Requires credit approval
Floor
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Other ProductsOther Products
FEATUREFEATUREPRODUCTPRODUCT
Shorter Floor allows for prepaymentShorter Floor allows for prepaymentPrepay CollarPrepay Collar
Lowers cash flow in early yearsLowers cash flow in early yearsStepStep--Up SwapUp Swap
Allows prepayment at no costAllows prepayment at no costPrepay SwapPrepay Swap
Fixed rate for uncertain draw schedulesFixed rate for uncertain draw schedulesFlexiSwapFlexiSwap
Lowers rate on Swap with some riskLowers rate on Swap with some riskKnockout SwapKnockout Swap
Sets maximum fixed rateSets maximum fixed rateSwaptionSwaption
Sets forward Treasury rateSets forward Treasury rateTreasury LockTreasury Lock
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Swap vs. Swap vs. Traditional Fixed RateTraditional Fixed Rate
Swaps offer:Swaps offer:Favorable prepayment termsFavorable prepayment termsControl over the timing of the rateControl over the timing of the rateCustomized pricingCustomized pricing
Cash flow assistanceCash flow assistancePrepayment optionsPrepayment optionsLonger tenorsLonger tenorsPartial fixed ratesPartial fixed rates
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ISDA Agreement & Schedule ISDA Agreement & Schedule ““Master Master AgreementAgreement””Confirmation
Corporate ResolutionCorporate ResolutionTrading AuthorizationTrading AuthorizationWW--99Organization Chart with equity stakesOrganization Chart with equity stakesStatement of IncorporationStatement of Incorporation
Needed for Trading Approval:
Standard Swap DocumentsStandard Swap Documents
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Master AgreementMaster Agreement
Available through Available through www.isda.orgwww.isda.org1992 and 2002 versions in use1992 and 2002 versions in useAll changes noted in the Schedule All changes noted in the Schedule portionportion90% of the Master is standard90% of the Master is standardOne agreement per legal entityOne agreement per legal entityItIt’’s negotiable!s negotiable!
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Standard Credit TermsStandard Credit Terms
References loan agreementReferences loan agreement
No new covenants No new covenants
No new credit entitiesNo new credit entities
Loan should trigger firstLoan should trigger first
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Credit Terms DocumentedCredit Terms Documented
Part 1(a): Specified Entity: NonePart 1(a): Specified Entity: None
Part 1(c): Cross Default: Will apply to both Part 1(c): Cross Default: Will apply to both parties, and Threshold Amount should parties, and Threshold Amount should match the loan agreementmatch the loan agreement
Part 5(b): Right of SetPart 5(b): Right of Set--Off should be Off should be includedincluded
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Prepayment ComparisonPrepayment Comparison
($2,064,690)($2,064,690)($1,517,550)($1,517,550)($1,185,833($1,185,833Rates Rates -- 200 bps200 bps
($1,433,917)($1,433,917)($896,350)($896,350)($583,764)($583,764)Rates Rates -- 100 bps100 bps
($229,630)($229,630)$0$0$566,035$566,035Rates + 100 bpsRates + 100 bps
$1,114,899$1,114,899
Two Way Two Way Market ValueMarket Value
SWAPSWAP
$345,198$345,198$0$0Rates + 200 bpsRates + 200 bps
DefeasanceDefeasanceYield Yield MaintenanceMaintenance
Prepayment Prepayment Calculation:Calculation:
CONDUITCONDUITLOANLOANProduct:Product:
Swaps compare favorably to conventional fixed rate loans and to conduit financings when it comes to prepayment terms.
Assuming $20 million loan, prepaid with 3 years remaining.
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Prepayment CalculationPrepayment Calculation
Present Value of:Present Value of:
(Contract Swap Rate (Contract Swap Rate –– Current Swap Rate) x Current Swap Rate) x Average Balance x Years RemainingAverage Balance x Years Remaining
Borrower can receive payment upon Borrower can receive payment upon terminating!terminating!
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Swap PrepaymentSwap Prepayment
Most valued featureMost valued featureAllows borrower to put continual pressure Allows borrower to put continual pressure on lending credit spreadon lending credit spreadLowers switching costs on refinancingLowers switching costs on refinancingBorrower owns economic value of hedge Borrower owns economic value of hedge making his rate portable making his rate portable
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Prepayment DocumentedPrepayment Documented
For Events of Default and Early Termination For Events of Default and Early Termination Events (INVOLUNTARY)Events (INVOLUNTARY)
Part 1(e): Automatic Early Termination: Part 1(e): Automatic Early Termination: will not applywill not apply
Part 1(g): Payments on Early Termination: Part 1(g): Payments on Early Termination: Market Quotation (not Loss) and Second Market Quotation (not Loss) and Second Method (twoMethod (two--way payments) should applyway payments) should apply
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Prepayment DocumentedPrepayment Documented
Part 1(h): Additional Termination Event: Part 1(h): Additional Termination Event: will not apply (but may concede loan will not apply (but may concede loan termination) termination)
Part 5(f): Consent to Transfer will not Part 5(f): Consent to Transfer will not apply, or will not be unreasonable withheld, apply, or will not be unreasonable withheld, or only if loan transfersor only if loan transfers
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Prepayment Language?Prepayment Language?
Swap documentation does NOT allow for Swap documentation does NOT allow for VOLUNTARY prepaymentVOLUNTARY prepaymentBorrower can: Borrower can:
TerminateTerminateAssignAssignReverse SwapReverse Swap
Termination amounts are negotiable! Termination amounts are negotiable! (includes a bank profit margin)(includes a bank profit margin)
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Additional Swap DocumentsAdditional Swap Documents
Cap Collateral AgreementCap Collateral AgreementCredit Support AgreementCredit Support AgreementTermination AgreementTermination AgreementAssignment AgreementAssignment AgreementDisclosure StatementDisclosure StatementHedge Designation MemoHedge Designation Memo
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NonNon--Lender ParticipationLender Participation
Increase competition for each transactionIncrease competition for each transaction
““Cherry pickCherry pick”” best loan and swap pricebest loan and swap price
Widen banking groupWiden banking group
Improve future lending termsImprove future lending terms
Bank lender CANNOT require hedge with itselfBank lender CANNOT require hedge with itself
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NonNon--Lender DocumentedLender Documented
Credit Support Agreement (CSA) Credit Support Agreement (CSA) allows a borrower to offer cash allows a borrower to offer cash collateral to a noncollateral to a non--lender hedge lender hedge providerproviderBelow the Threshold Amount, Below the Threshold Amount, unsecured exposureunsecured exposureAbove the Threshold Amount, a cash Above the Threshold Amount, a cash escrow accountescrow account
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NonNon--Lender Documented (2)Lender Documented (2)
Escrow amount for monthly call, quarterly Escrow amount for monthly call, quarterly call, or full term (approx. 1%, 3%, or 10% call, or full term (approx. 1%, 3%, or 10% of principal respectively) of principal respectively) Market to markets daily, monthly, or Market to markets daily, monthly, or quarterlyquarterlyUnsecured Threshold Amount usually Unsecured Threshold Amount usually $100,000$100,000Increments to post additional collateral Increments to post additional collateral usually $25,000usually $25,000
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Conduit Hedges DocumentedConduit Hedges Documented
Typically Caps onlyTypically Caps onlyAdditional Cap Language requiredAdditional Cap Language required
–– Decreases biddersDecreases biddersLegal opinion of hedge provider typically Legal opinion of hedge provider typically requiredrequiredCredit Downgrade Provision: Transfer or Credit Downgrade Provision: Transfer or post collateral requirementpost collateral requirement
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Timing Matters!Timing Matters!
Negotiate execution window Negotiate execution window –– Often determines priceOften determines price–– Affects number and quality of Affects number and quality of
biddersbiddersLeaveLeave--orders and stoporders and stop--losses can be losses can be used very effectivelyused very effectively
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Documents Affect TimingDocuments Affect Timing
Master Agreement up to 45 days post tradeMaster Agreement up to 45 days post tradeReview draft prior to tradingReview draft prior to trading
Confirmation up to 48 hours post tradeConfirmation up to 48 hours post tradeEmail statement often can meet Email statement often can meet requirement for closingrequirement for closingVerbatim conduit language often not Verbatim conduit language often not necessarynecessary
Legal opinion up to 60 days post tradeLegal opinion up to 60 days post trade
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Documentation Best PracticesDocumentation Best Practices
Review drafts before tradingReview drafts before trading
Negotiate MasterNegotiate Master
Negotiate credit termsNegotiate credit terms
Plan on document turnaround timePlan on document turnaround time
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Best practices on executionBest practices on execution
Get transparencyGet transparencyBid it outBid it outObtain credit amount Obtain credit amount Ensure no more than loan returnEnsure no more than loan returnNegotiate an execution windowNegotiate an execution windowEmploy leaveEmploy leave--orders and stoporders and stop--losseslossesCheck the internetCheck the internetHire a brokerHire a broker
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Client advocates forborrowers ensuringthe lowest rates andbest terms in thehedging market
Elaine PhilbrickElaine Philbrick 617.283.4088617.283.4088
Rob PrattRob Pratt 617.680.2402617.680.2402
Tom KennedyTom Kennedy 508.523.4891508.523.4891
Derivative Advisors is dedicated to bringing its extensive knowledge and experience as an industry insider to the benefit of its clients.