Derivative Markets

Sessions 15&16

Agenda
1. EU Stress Tests for Commercial Banks- Quick
look
2. Quick recap of last session
3. Currency Swaps
4. Asset and Par Asset Swaps( Customisation!!)
5. Quick introduction to Credit Derivatives

So, help me God!

Monte dei Paschi de

Siena
Raised 8b in 2014, burned!
JPM and UBS trying to raise 5b and sell
10bn NPAs before the Stress Test Results
Purchase of Antoveneta in 2008 was a
disaster.
M&A in the banking industry?

DB under the lens

2014 , raised $8b of capital and grew its IB
business( Unlike CS and UBS)
Market value of 17.7bn, just a quarter of the
book value.
Will be forced to raise Capital after the Stress
Tests( low price to market , difficult)
Plan to sell PostBank for 5b( no buyers in sight!)
Cut IB and lay off 10,000 staff and close down in
10 countries

1. Fixing Financing
Costs
A company currently borrowing at 6MLIBOR+100bps fears that interest rates
may rise in the three remaining years of its
loan.
It enters into a 3 year s.a. vanilla IRS as a
fixed rate payer @ 3.75% against receiving
6M-LIBOR.
This fixes the companys borrowing cost at
4.75% s.a( 4.81% p.a.) for the next 3 years

2. Asset Linked Swap

A US based insurance company is seeking to improve
the yield on its portfolio of US$ denominated securities.
10 year US T-bonds are currently yielding 4.14% while
German Bunds are offering a return of 4.45% for bonds
of a similar tenor.
A Bank is quoting for the Insurance Company to receive
US$ Fixed @ 4.51% against paying EUR 4.45% Fixed.
37bps pick up!
( Final Exchange is what?)

Cross Currency Swaps

Special kind of IRS, EXCEPT
1. Currencies of the two legs are DIFFERENT
2.There is always EXCHANGE of Principals at
Maturity
3.There is optionally exchange of principal on
the effective date
4.Both the exchanges of principal are
executed at the SPOT rate originally prevailing

Definition continued
The legs may be
- both FIXED rate
-both FLOATING rate
-one fixed and one floating
Alternatively , an IRS is a special kind of CCS for
which both currencies are the SAME.
In that analogy the exchange of principals is
irrelevant!

Nuances
Drivers of Currency Swaps are Interest
Rates and not SPOT rates
Interest rates determine the size of each
regular payment not the spot rate
Thus a Currency Swap is an IRS where the
interest rates and regular payments are
denominated in a pair of currencies rather
than a single currency.

One more nuance!

The mandatory FINAL exchange of principals is
always a standard feature of standard CCS.
This may appear to create currency risk at first
glance!
Paradoxically, it is the final exchange of principals
which removes the currency risk that would
otherwise be present!
In practice, it does not matter if there is an initial
exchange of principals.
This can be negated by a spot deal at inception

3. Liability Linked Swap

A British Company , having already made
extensive use of the domestic capital market is
now seeking to raise additional finance.
However the quotes of 6.50% fixed or L+90bps
floating reflect the reluctance of the Bank loan
market to provide further funds at this time.
The company therefore decides to turn to the
EUR bond market where it can raise funds at
4.75%.
The company is now exposed to Currency Risk!

(3) continued
GBP could weaken against the EUR!
It enters into a Fixed-Floating GBP/EUR CCS.
Pay GBP L+50bps against receiving EUR
fixed at 4.75%
Net result is shown in the figure where it
secures SYNTHETIC GBP funding at
L+50bps , which is 40bps CHEAPER than by
borrowing in the GBP loan market!

ISDA Documentation
2002 Master Agreement usually
accompanied by the ISDA-CSA( Credit
Support Annex).
Suppose that two years have elapsed since
two counterparties-ABC and XYZ- entered
into a 5 year swap contract with a notional of
US$10m and a fixed rate of 4%.
Assume , now the floating rate is 3% and is
likely to remain that way for the next 3 years.

Story
ABC therefore expects to receive about
US$300,000 from XYZ the payer.
If XYZ were to default, ABC is exposed to US$0.3m
To avoid this , under CSA, XYZ would have posted
US$0.3m worth of collateral.
This involves (1) Time value of moneyDiscounting US$0.3m to the present value
(2)Potential Future exposure- possibility of rates
rising or falling

Story Continued
(3) Quality of Collateral posted by XYZ.
CSA documentation covers: who is responsible for
calculating the amount of collateral, what
collateral is eligible, exact process for posting and
return of collateral and who actually owns the
collateral, dispute resolution.
When Lehman collapsed its swaps book comprised
66,000 trades across 5 major currencies and was
valued at $6tn notional.( LCH Clearnet)
No counterparty was affected thanks to CSA!

Some Facts!
Clearing houses have been a feature of
Futures markets
Similar organisations have been created
for the OTC markets.
Its part of US Law ( Dodd-Frank Act 2010DFA) and in Europe as EMIR ( European
Market Infrastructure regulation)

Alphabet Soup
DFA mandates that all trading in
standardised OTC derivatives be executed
in a DCM( Designated Contracts Market) or
a SEF ( Swap execution facility)
The SEF requires that all trades be cleared
by a DCO ( Derivatives Clearing
Organisation).
Now , all OTC swaps , Vanilla Swaps,CDS
and Credit Indices are covered by the DFA.

Asset Swaps and Par

Asset Swaps
Fin17 is thinking of buying a 5 year bond
with a coupon of 6.5% at a price of 97.
Fin17 is exposing herself to Interest Rate
risk
Fin17 believes that Interest Rates will RISE.
One solution is to go for a Vanilla Swap.
Is this perfect?

Not perfect
It goes some way towards removing interest rate risk.
1. Rarely will the 5 year swap fixed rate match the
coupon. Usually there is a mismatch
In our example, vanilla swap rates of 5% will convert
most of the 6.5% coupon into a floating payment, but
still leave a residual.
Supposing that the bank tailors the fixed rate of the
swap to match the coupons on the bond.
Adding 1.5% to the fixed rate means adding 1.5% to
the floating rate?

Asset Swap
Tailoring the swap involves
Setting the final maturity of the swap to match
the maturity date of the bond
Matching the payment dates of the swap to
that of the coupon dates of the bond
Matching the day count convention of the swap
to that of the bond
This means that the floating rate could be
L+147bps or L+152bps .

Finicky Fin17
Wants to pay par for the bond rather than pay
premium or discount price.
One way to handle this is for the swap to feature an
up-front payment equal to the off-par amount.
Figure.
Fin17 makes the swap counterparty a one off
payment of 3% upfront, making the total
investment 100.
This is the same as Fin17 lending 300bps to the
swap counterparty

TV
PV=300,N=10,r=5% ,P/YR=2 and solve for
PMT, we get 68.6 per year
Spreading the 300bps upfront payment over 5
years gives an equivalent of 70bps / year
In the figure we have added this 70bps to give
a

par asset swap rate of L+220bps

The 220bps is the par asset swap

spread

Final position of Fin17

Buy the bond @ 97 and immediately enter into a par
asset swap. Fin 17 pays par for the investment and
receives L+220bps for 5 years with an eventual
redemption at par
The value of the par asset swap package will never
drift far from par as Fin17 is receiving a floating rate.
If rates go up, flow of payments go up as well,
removing the normally detrimental effect of a rise in
interest rates on a fixed income investment.
Interest rate risk has been virtually ELIMINATED

History- Derivatives
Been around for more than 100 years now.
CBOT introduced commodity futures in the
middle of the 19th century.
Equity Options 100 years or so but CBOE in
1973 ( year of Black Scholes Model).
Currency Futures in CME 1973
STIRs 1975
Stock Index and IRS in 1982.

Derivatives
Covered almost all types of Risk.
What other type of risk is there?
Oldest Financial Risk is CREDIT Risk!
Whenever one person borrows from
another( age-old problem).
Credit Derivatives , largely CDS
Credit Indices

JPM
The first to devise and execute a Credit Derivative
Transaction.
1994- Exxon , one of its major customers sought a
US$5b line of credit to fund liabilities arising from
the 1989 Exxon Valdiz disaster.
JPM was reluctant to take on the Credit Risk, also it
had to keep extra regulatory capital
How could JPM provide the credit line to a valued
customer at the same time avoid keeping extra
capital?

Blythe Masters
Boca Raton

Example Points
Credit Derivative: TRANSFER of credit risk between
two parties : Protection BUYER and PROTECTION
seller.
Separation of funding and credit risk.(*****).
JPM funded Exxon while EBRD took on Credit Risk
Since Monte de Paschi de Siena was formed in 1472
as the worlds first bank, for 5 centuries (*****) was
impossible to separate!
Now a bank could lend without being exposed to the
credit risk of the borrower!

Credit Derivatives
-Markit, CDX, and iTraxx are now standard pricing
sources, further enabling broad trading of credit
derivatives.
-Chicago Mercantile Exchange (CME) considers listing
standardized single name CDS contracts to create the
first large retail market.
-DTCC clearing system development increases speed
of trade clearing and settlement, reduces costs and
operational risks.
-Notional value of single name CDS outstanding now
$19-25 trillion versus $40 trillion in bonds.

Reference Entity
Sovereign and FIs topping the list
Consumer Goods and Services
Telecoms and Technology
Industrials

Motivations: Credit
Derivatives
1. Protect investors from losses arising from
Bonds( Loans) in their portfolio that may default.
Early 2001:You hold US$10m face value bonds
issued by Pacific Gas and Electric.(PG&E)
Buy a CDS with a notional of US$10m
referencing PG&E.
6 April 2001, PG&E filed for bankruptcy.
You simply hand over the bonds to the
protection seller and receive US$10m

2. To hedge
Against or position for a change in perceived
credit quality
Until CDS came along, CREDIT SPREADS
referred to the difference between the yield
on a risky corporate bond and the yield on a(
assumed riskless) government bond.
Now: Credit Spread is the premium of a CDS
Annual cost of buying credit protection on
the same issuer

Example
Date : 15 Aug 2011.
Investor believes that a worsening economy
will reduce discretionary expenditure and as a
result, the annual premium or cost for CDS
issued by Walt Disney Corp(DIS)-then trading
at 40bps p.a. is going to INCREASE.
The investor could buy 5 year protection on
DIS on a notional principal of US$10m
agreeing to pay US$40,000 per year for the
next 5 years.

15 Sep 2011
Premiums had widened to 48bps p.a.
The investor executes a second transaction,
selling 5 year protection on DIS for the same
notional principal and expiry as the previous
transaction. He receives US$48,000 p.a. for the
next 5 years.
The difference between these two cash flows
amounts to some US$40,000 in total.( little less
as we have to PV these cash-flows).
This is the net profit from these two transactions.

Intro to CDS
A single name CDS is a derivative contract
involving two counterparties.
A protection buyer agrees to transfer to the
protection seller the credit risk of a particular
third-party borrower on a given notional principal
amount for a specified period of time and in so
doing, agrees to pay the protection seller an
annual fee for the duration of the contract.
The third party is called REFERENCE entity.( e.g.
Deutsche Bank, French Republic, AT&T)

CDS intro continued.

The standard period quoted by a CDS is 5 years, but
a CDS contract can run from 1 to 10 years , or even
longer.
The annual fee is quoted as basis points per annum
as a % of the notional principal.
This annual rate is called premium or SPREAD, but is
actually paid in quarterly installments.
In the event the reference entity experiences a
credit event like bankruptcy , the protection seller
compensates the protection buyer for the financial
loss incurred.

Important Concepts
Protection Buyer/Seller
Notional Principal
Reference Entity
Period of time covered by the CDS
Annual premium rate ( spread)
Series of Quarterly Premium Payments
Contingent payment following a credit
event