Interest Rate Swaps Financial Markets, Day 3, Class 4 Jun Pan - - PowerPoint PPT Presentation

Interest Rate Swaps

Financial Markets, Day 3, Class 4

Jun Pan

Shanghai Advanced Institute of Finance (SAIF) Shanghai Jiao Tong University April 20, 2019

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Outline

Pricing of Interest-Rate Swaps. Using Interest-Rate Swaps. OTC Derivatives.

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Modern Finance

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Portfolio Theory (Markowitz) Two-Fund Separation (Tobin) Investments and Capital Structure (Modigliani and Miller) CAPM (Sharpe) Efficient Markets Hypothesis (Samuelson, Fama) Mutual Funds Study (Jensen) Birth of Index Funds (McQuown) Option Pricing Theory (Black, Scholes, Merton) First US Options Exchange, CBOE Index Mutual Funds (Bogle) Rise of Junk Bonds (Michael Milken) Mortgage Backed Securities (Fannie Mae) First Stock Index Futures OTC Derivatives Interest Rate Swaps Stock Market Crash S&L Bailout Collapse of Junk Bonds Large Derivatives Losses Credit Derivatives (CDS) First TIPS Asian Crisis LTCM Crisis Dot-Com Peak Enron Scandal WorldCom Scandal Financial Crisis Dodd-Frank European Sovereign Crisis Chinese Stock Market Crash Trump Trade War

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Interest Rate Swap

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Treasury and Swap Curves, November 13, 2012

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Treasury and Swap Curves, April 2007

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LIBOR Spread

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Swap Curve

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Treasury Curve

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Swap Spread

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Exposure to counterparty risk

At inception swaps have no value. The counterparty for which the swap value becomes positive has a credit exposure on the other counterparty equal to the value of the swap. The practice of posting collateral are used to limit the potential counterparty credit risk. Marked to the market on a regular basis (monthly or even daily between swap dealers), the counterparty with a negative value has to deliver an amount in collateral (most usually cash or Treasury bonds) proportional to the value of the swap. Most participants in the market and dealer banks have minimum rating requirements for their counterparties. Weaker counterparties would be denied access to the swap market or experience very tight collateral requirements. The collateral requirements are normally tightened in the event of a downgrading.

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Swap spreads: Swap Rate - Treasury Rate

What are the possible determinants of the Swap Spreads? Treasury supply Counterparty risk Credit risk

▶ The spread of three-month LIBOR (unsecured borrowing) over

three-month general collateral term repo (secured borrowing).

▶ The AA credit spreads

Liquidity convenience yield of treasury bonds

▶ On-ofg-the-run treasury bond yield difgerential

Mortgage backed securities (MBS) and hedging activities

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Swap spread = swap rate - yield of on-the-run treasury:

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Negative Swap Spreads after Lehman

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MBS Negative Convexity Hedging

Because of the prepayment options given to homeowners/mortgage borrowers, mortgage-backed securities (MBS) have negative convexity. Interest rates fall: MBS duration shortens; need to buy back duration. Hedging with IR swaps: add receive-fjxed or terminate pay-fjxed. Interest rates increase: MBS duration increases; need to sell duration. Hedging with IR swaps: add pay-fjxed.

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Mortgage-Backed Security, Yield and Duration

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Treasury, Yield and Duration

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Relation between Duration and Yield

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Risk Management Derivatives, Fannie Mae 2010 10K

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Interest Rate Sensitivity of Net Portfolio, Fannie Mae 2014

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MBS Footprint on Swaps

The developments in the markets are such that swaps have behaved far more effjciently than Treasurys as a hedging instrument for MBS. Most of these hedging activities center around 5-10yr IR Swaps. The sharp increase of 10yr rates in summer 2003 resulted in a sudden increase in MBS duration. As a result, there were increasing amount

• f fjxed-payers, efgectively putting a selling pressure on the “swap

bond.” This resulted in a temporary spike in the 10yr swap spread (a footprint of MBS hedging on the swap market).

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LIBOR/Swap Spread in 2003

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The Global OTC Derivatives Market

The global OTC derivatives market had its beginning in the mid-1980s. Over the past 30 years, it has grown into an important part of the global fjnancial markets, allowing business to manage and hedge fjnancial risk. By far, the most important segment of this market is interest-rate

• product. As such, most of the hedging activities on interest rate risk

have migrated from Treasury bonds to interest rate swaps. In addition, it also provides derivatives on currency, credit, equity, and commodities.

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OTC Derivatives, Amounts Outstanding

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OTC Derivatives, Market Value

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Derivatives Usage

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