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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


Swap Market volume trendsSwap Market volume trends Swaps Definition and Conventions


Pricing Swaps:

Adapt to the market reality

Pricing Swaps:



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


Swap Market volume trendsSwap Market volume trends Swaps Definition and Conventions Swaps Definition and Conventions

Swap Strategies

Pricing Swaps:


Pricing Swaps:



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



6.5% EUR5% EUR

7% GBP8% GBP

Gain 1% GBP & 1.5% EUR !

English Corporate

Need EUR

German Corporate

Need GBP


Difference

English/German




8% GBP5% EUR

Gain 50 bp GBP Gain 50 bp EUR

Example of a Cross Currency Swap 3/3 (Maturity)

Swap

Bank



10m principal GBP10m principal GBP

12m principal EUR12m principal EUR

English Corporate

Need USD

German Corporate

Need GBP


10m principal GBP12m principal EUR


Difference

English/German



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




Pricing Swaps:


Pricing Swaps:


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

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




Pricing Swaps:



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




Pricing Swaps:


Pricing Swaps:



Q & A

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