understanding and managing option risk - gsb

No Slide TitleDwyer Capital Strategies L.L.C. Bloomington, MN
[email protected] 952-681-7920
Dwyer Capital Strategies L.L.C. Financial Institution Advisory Services
Understanding and Managing Option Risk
Daniel J. Dwyer Managing Principal Bloomington, MN
[email protected] 952.681.7920
Introduction
What the course expects to convey: An overview of "Optionality", and the influence on daily financial management
A broader discussion of derivative-based products and strategies - and the implications to balance sheet management
The concepts of structuring and applying options to protect net interest margin from interest rate risk
The concept of options as “insurance policies” that can help an institution manage its Economic Value of Equity (EVE/NEV) metrics
Specific examples of macro-level swap/option strategies utilized by financial institutions
Creative "facility-level" pricing strategies utilizing options to benefit the borrower and organization
High-level overview of the broader capital markets, and the theory behind the pricing of such strategies - Calculating actual costs to implementation
Discussion of the risks associated with these option-based strategies, and a look at documentation and due-diligence required
3Dwyer Capital Strategies L.L.C. - Bloomington, MN - [email protected]
Types of Interest Rate Risk
Interest Rate Risk
Components of Interest Rate Risk (Per the Federal Reserve Bank*)
*(See Basel Committee on Banking Supervision (BCBS) 2003)
Components of Interest Rate Risk Optionality (Option Risk)
“Optionality”:
“…Refers to risks arising from interest rate options embedded in a bank assets, liabilities, and off balance-sheet positions…”
“…Such options can be explicitly purchased from established markets (such as) interest rate derivatives or included as a term within a loan contract, such as the prepayment option included in residential mortgages…”
Taken from FRBSF Economic Letter 2004-26 September 17, 2004 – Jose A. Lopez
Interest Rate Risk and “Optionality”
“Optionality” Optionality = An embedded rule in the terms of the instrument that
allows for a change in cashflow characteristics. Auto Loan
Amount = $10,000 Rate = 3 Month Libor - “Floating” (Currently 1.20%) + 2.00%* Maturity = 4 Years * Interest Rate has a contractual “Floor” of 2.50%*
Fixed Rate CD Amount = $10,000 Rate = 2.00%* Maturity = 4 Years *Purchaser is allowed a “1-Time” Rate increase
Options = “Arbitrary” Changes in a Cashflow
Call Option
Put Option
Cancel Option
Derivatives - Applications
Modifying Cashflows
An Asset/Liability Manager’s primary function is to manage the institution’s cashflows.
In fact, the reasonable expectation of cashflows constitutes the primary driver to an institution’s profitability.
As we established, modifying cashflows is the primary function of financial derivatives.
On a daily basis, what decisions are based on cashflows?
Loans
Investments
Deposits
Capital
Each additional earning asset or IBL applied to the balance sheet has the potential to alter a bank’s interest rate risk profile. These facilities are added on a daily basis.
Therefore, knowing the bank’s interest rate risk profile, (and how the derivatives marketplace can assist in minimizing risk) is valuable information to be used on a daily basis.
Where is Optionality Found?
* Strategies *
Utilizing a “like” structured traditional facility to offset/cancel the option risk.
EXAMPLE:
“Match-Fund” a loan facility with a similarly structured funding source with like (offsetting) option features.
Synthetic Strategies
Utilizing an “Off Balance Sheet” Derivative structure to “Overlay” the facility - negating the option risk.
EXAMPLE:
Engage an interest rate swap to “Overlay” a loan facility with opposite option characteristics
* Strengths and Weaknesses *
“Organic” vs. “Synthetic”
Managing Option Risk
Utilizing a “like” structured traditional facility to offset/cancel the option risk. Strengths:
Familiarity
Synthetic Strategies
Utilizing an “Off Balance Sheet” Derivative structure to “Overlay” the facility - negating the option risk. Strengths:
Highly Effective
* The “Organic” Strategy *
EXAMPLE:
“Match-Fund” a loan facility with a similarly structured funding source
with like (offsetting) option features.
Potential Risk
Pool of Fixed Rate Loans
Option Risk? = Option to Prepay!
(Borrower has the option to prepay the loan should rates be advantageous (Rates Fall,
borrower has incentive to refinance.)
Option Risk Hedge
FHLB Fixed Rate Advances
•Embed the “Member Option”
(“Member Option” is an embedded option that allows the User of the facility to cancel the
advance without penalty.)
* The “Organic” Strategy *
“Organic Strategy” Implications
EXAMPLE:
“Match-Fund” a loan facility with a similarly structured funding source
with like (offsetting) option features.
Implications of “Organic” Strategies
o Balance Sheet Capital / Liquidity Ratio Ramifications
o Option Price Inefficiency
o Lack of Customization
o Lack of Liquidity
* The “Synthetic” Strategy *
Synthetic Strategy – “Off Balance Sheet”
Utilizing an “Off Balance Sheet” Derivative structure to “Overlay” the facility -
Negating the option risk.
EXAMPLE:
Engage an interest rate swap to “Overlay” a loan facility with opposite optionality
Advantages of “Synthetic” Strategies
o Fully “Customizable”
o Highly Liquid
Applied Theory of the Hedging Index
What Financial Institution Managers
The Repricing “Index”
are periodically adjusted.” (The adjusted interest rate of an interest-sensitive asset or liability.)
Most Common to Community Financial Institutions: Prime Rate
Fed Funds (Federal Reserve Target)
Libor
CMT
Current Markets
Fed Target and 3 Month Libor (Swaps) correlate closely Prime maintains a historical spread to Libor / Fed Target of 275-300 bps
Why are we talking about these indices?
Definitions
Fed Target Rate (Federal Funds Rate – or - FDTR):
The “Fed Target Rate” is the “Theoretical” short term (overnight) interest rate as set by the Federal Reserve’s Open Market Committee (FOMC) as part of its monetary policy. The rate signifies theoretical overnight borrowing between the highest quality banks. (Typically set/adjusted 8X per year.)
Libor (London Interbank offering rate):
“Actual” average rate charged by/between highest quality banks to borrow overnight funds.
Prime Rate:
The rate that a commercial bank offers to its theoretical “Most credit Worthy” borrowers. Rate consistently is set at 300 bps above Fed Target, and moves in lockstep.
A Note on Prime vs. Fed Target
Historical Perspective
A Note on Fed Target vs. 3 Month Libor
Correlation of Indices
Fed Target and 3 Month Libor (Swaps) correlate closely Prime maintains a historical spread to Libor / Fed Target of 275-300 bps
Correlation of Indices
Note the Exception to the Correlation Due to Dislocation of Markets in 2008
Basis Risk
Close Correlation
Why are talking about 3-Month Libor???
Significance of 3-Month Libor
- 3-Month Libor is an “actual” rate being charged for overnight borrowing between financial institutions.
-Hedging against these overnight borrowing rates (Libor) is one of the largest and most liquid futures markets in the world. (90-Day Eurodollar Futures).
In other words…
- We can use the “Market-Based” future path of Libor Rates to get an “Equivalent” Fixed rate. (i.e.. Fixed “Swap” Rate).
Why are talking about 3-Month Libor???
3-Month Libor is the most widely used index for determining a “Fixed” Rate to be paid over time. (It also closely correlates to Fed Target and Prime.)
In other words…
The “Swap Rate” is the fixed rate that receiver demands in exchange for the uncertainty of having to pay the short-term LIBOR (floating) rate over time.
And Therefore…
Since Libor and Prime closely correlate, the “Swaps” market is an ideal tool to alter a facility’s interest rate risk profile.
Libor 3 Month Libor 2005 – Present
October 10th, 2008 4.82%
Derivative Based Products
“Derivatives” – For this discussion
An Interest Rate Derivative (Swap, Cap, Floor) is an exchange of interest flows without an exchange of principal
The derivative is a wholly separate and distinct contract from the facility being hedged
Completely customizable with flexible terms
Payments are based upon a “Notional” amount of the swap (i.e. theoretical value upon which interest payments are calculated)
Typically, one party pays a fixed rate of interest (or fixed payment), while the other pays a floating rate (or variable ongoing payments)
Floating rate is benchmarked to some widely available index – (usually 3-Month LIBOR)
The exchange is affected by the net difference in payments from each party paying fixed or variable rates to the other
For this discussion, we will focus on two types of
interest rate derivatives that are used in managing Option Risk:
Interest Rate Swaps
An agreement between two parties to pay interest on an agreed-upon dollar amount (Notional Amount) for an agreed-upon period of time (Tenor). The difference lies in the characteristics of the interest payments. Typically, one party pays a fixed interest rate, while the other pays a floating rate based on a recognized “index”.
Interest Rate Caps and Floors - (Interest Rate Options)
The interest rate cap is an option product, functioning much like an "insurance policy“. It protects the buyer against rising (falling) interest rates. It is purchased via a one-time, upfront premium. In return the seller agrees to reimburse the buyer should the index rate exceed the strike rate on the cap.
Derivatives - Relevant Tools
“Options” – Formal Definition The formal definition of Interest Rate Options –
And the Subset (Caps / Floors) - are defined as follows:
Interest Rate OPTIONS – Purest Definition Interest rate “options” – A SUB-CLASS OF DERIVATIVES - are offered on Treasury bond futures, Treasury note futures and Eurodollar (Libor) futures. An investor taking a long position in interest rate call options believes that interest rates will rise, while an investor taking a position in interest rate put options believes that interest rates will fall.
Interest Rate CAP (Floor) – Purest Definition An interest rate cap (floor) is actually a series of European interest call options (called caplets), with a particular interest rate, each of which expire on a specific date (reset).
By definition, Options also include non-vanilla Swap structures – Such as:
o Swaptions o Cancelable Swaps o Swaption Straddles
Derivatives – The Marketplace
Interest Rate Swaps
Interest Rate Swaps
•An agreement between two parties to pay interest on an agreed-upon dollar amount (Notional Amount - Theoretical) for an agreed-upon period of time (Tenor).
•The difference lies in the characteristics of the interest payments.
•Typically, one party pays a fixed interest rate, while the other pays a floating rate based on a recognized “index”.
By “Swapping” a fixed payment for a floating receipt, organization is more “Asset Sensitive”.
Swaps - A Typical Transaction
The Swap An agreement between two parties to pay interest on an agreed-upon dollar amount (Notional Amount) for an agreed-upon period of time (Tenor).
The difference lies in the characteristics of the interest payments.
Typically, one party pays a fixed interest rate, while the other pays a floating rate based on a recognized “index” - i.e. Libor.
A Typical Swap Transaction
Fixed Swap Rate
From an interest rate risk perspective, note how the Bank has just become more asset sensitive: Added a floating rate asset (receiving Libor floating) - and added a fixed rate liability (paying fixed).
Reflected in the graph below, a Bank has elected to pay fixed in a swap contract.
Given the forward LIBOR curve, or “Swap” curve, the fixed rate of 3.00% paid will initially be higher than the current floating 2.30% LIBOR rate received. But after some time, this fixed 3.0% will be lower than the floating rate.
Swaps - A Typical Transaction
Determining the “FIXED” Swap Rate:
At the time of the swap agreement, the total value of the swap’s fixed rate flows will be equal to the value of expected floating rate payments implied by the forward LIBOR curve.
As forward expectations for LIBOR change, so will the fixed rate that investors demand to enter into new swaps. Swaps are typically quoted in this fixed rate.
Determining the Fixed Rate
Liquidity – Market Value All Transactions are considered a “Liquid” agreement…
…Meaning that at any given time, a market value can be determined
At any given time, there is either a positive or negative market value
This market value is determined by the current LIBOR and swap rates
As forward expectations for LIBOR change, so will the market value
Interest Rate Caps (Floors)
Interest Rate Cap Mechanics
The interest rate cap is an option product, functioning much like an "insurance policy"
It protects the buyer against rising short-term interest rates.
It is purchased by the buyer via a one-time, upfront premium.
In return the seller agrees to reimburse the buyer should the index rate exceed the strike rate on the cap:
Provides a limit on the customer's effective interest rate Provides protection against rising rates without fixing the rate Buyer retains all of the benefits of declines in short term rates
The seller of the Cap makes a payment to the buyer when the short-term benchmark index rate (e.g. LIBOR) exceeds the Cap strike rate.
If the index is equal to or below the “strike rate” of the Cap, there is no payment.
If index rate is greater than the cap strike rate, buyer receives a payment from seller,
Payment is equal to the rate differential on the contract amount over the number of days in that period.
The upfront premium is determined primarily by the following factors:
Contract Notional Amount Theoretical dollar amount to be protected
Tenor Term of the insurance contract
Strike Rate The index rate that when exceeded, payments are remitted
Implied Rate Volatility high volatility = high cost
Shape and steepness of the swap curve The steeper the swap curve = The higher future Libor expectations = Higher cost
Interest Rate Cap Mechanics The cap functions as an interest rate insurance policy. In exchange for a one-time, up-front payment, the counterparty agrees to compensate the purchasing bank for the increment that the Index Rate rises above a chosen level (“the strike rate”).
4.50%
5.00%
5.50%
6.00%
6.50%
7.00%
7.50%
8.00%
8.50%
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Cap Rate Rate Paid Potential Rate Scenario
Payment to Cap Buyer
For informational Purposes Only
A Typical CAP Transaction Sample of Upfront premiums for certain structures
Based on $10 Million Notional Pricing as of May 29th, 2018
Rate and Price Determination
Determining the Cost of Hedge
1. The “swap rate” is the fixed interest rate that the receiver demands in exchange for the uncertainty of having to pay the short-term LIBOR (floating) rate over time.
2. The Cap/Floor’s “dollar price” is determined by the sum dollar cost of each “Caplet”:
3. At any given time, the market’s forecast of what LIBOR will be in the future is reflected in the “forward LIBOR curve”.
4. At the time a swap/option contract is put into place, it is theoretically priced “at the money”.
…Meaning that the total value of fixed interest-rate cash flows over the life of the swap is exactly equal to the expected value of floating interest-rate cash flows.
Therefore, at the inception of the swap, the “net present value,” or sum of expected profits and losses, will “theoretically” add up to zero.
Swaps / Options - Determining the Pricing
90-Day Eurodollar Forward Curve - June 1st, 2018 (vs. June 1, 2017)
When Will Rates Rise?
Swaps - Determining the Fixed Rate Plain Vanilla Swap Rates – By Maturity
(Based on Lib3M - As of May 29th, 2018)
Swaps - Determining the Fixed Rate
The Swap Curve (Based on Lib3M - As of May 29th, 2018)
Historical Perspective The Swap Curve
The plot of swap rates across all available maturities is known as the swap curve.
Swap rates incorporate a snapshot of the forward expectations for LIBOR
Also reflects the market’s perception of credit quality of “generic” AA-rated banks.
The “Swap Curve” – (2013 – Present)
The “Swap Curve” - Note the volatility!
Libor 3 Month Libor vs. 5 Year Swaps
Current Derivative / Option-Based Ideas for Liability Sensitive Financial Institutions
Liability Sensitive Financial Institution The “LIABILITY SENSITIVE” INSTITUTION The client is “liability sensitive”, and concerned about a rising rate environment in the near term
$ in 000's Detail regarding Repricing TOTAL
Reprice Window 0-1 YEAR 1-2 YEAR 2-3 YEAR 3-4 YEAR 4-5 YEAR 5+ YEAR
Due From/FF Sold 50,000 50,000
Investments 225,000 75,000 40,000 35,000 40,000 20,000 15,000
Loans 700,000 125,000 140,000 115,000 180,000 75,000 65,000
Other 25,000 25,000
Non-Mat Deposits 550,000 183,333 183,333 183,333
Fed Funds Purch 25,000 25,000
CD 300,000 105,000 65,000 70,000 35,000 25,000
Capital from TruPS 20,000 20,000 Other Capital 105,000 17,500 17,500 17,500 17,500 17,500 17,500
TOTAL 1,000,000 350,833 265,833 270,833 52,500 42,500 17,500
Gap Analysis
GAP (75,833) (85,833) (120,833) 167,500 52,500 62,500 CUMUL GAP (75,833) (161,667) (282,500) (115,000) (62,500) (0)
CUMUL GAP / TA -7.58% -16.17% -28.25% -11.50% -6.25% 0.00%
LIABILITY SENSITIVE INSTITUTION
Liability Sensitive Financial Institution Issue:
The client is “liability sensitive”, and concerned about a rising rate environment is on the horizon
Bank would prefer to maintain a more “neutral” or “less liability sensitive” A/L Gap position
Expected Transaction:
Bank identifies Trust Preferred facility as instrument to be hedged. Characteristics are as follows:
$20 Million
Maturity 2023
Bank Determines Appropriate Swap Structure Trust Preferred
3M oL +
Spread Counterparty
Bank Fixed Rate
Bank enters into a swap that synthetically converts the Trust Preferred facility to fixed rate
Bank “Pays Fixed”
Bank “Receives Floating”
Price Determination Issue:
Bank wishes to swap the interest rate on a Trust Preferred structure to a fixed rate for 5 years
Bank
Result:
Bank converts its $20mm Trust Preferred that is currently floating at 3-Month LIBOR + 200 Bps to a “Synthetic” rate of 4.75% fixed
5 Years $20,000,000 2.75% 3 Mo. Libor
Maturity date
Determine the appropriate term of the hedge
Bank would like to lock in a rate for the next 5 years
Determine the corresponding swap transaction.
Currently, the market indicates that the 5 year swap rate (based on 3 Mo. Libor) is 2.75%
Replace the 5 year swap rate for “Libor” in the equation to determine the corresponding fixed rate
3 Mo. Libor 2.75% + 200Bps = 4.75% FIXED RATE
3M oL + Spread
Gap Results The Result By swapping the TruPS to 5 year fixed, the institution becomes less “liability sensitive”
Investments 225,000 75,000 40,000 35,000 40,000 20,000 15,000
Loans 700,000 125,000 140,000 115,000 180,000 75,000 65,000
Other 25,000 25,000
Non-Mat Deposits 550,000 183,333 183,333 183,333
CD 300,000 105,000 65,000 70,000 35,000 25,000
Capital from TruPS 20,000 20,000 Other Capital 105,000 17,500 17,500 17,500 17,500 17,500 17,500
TOTAL 1,000,000 330,833 265,833 270,833 52,500 42,500 37,500
Gap Analysis
GAP (55,833) (85,833) (120,833) 167,500 52,500 42,500 CUMUL GAP (55,833) (141,667) (262,500) (95,000) (42,500) (0)
CUMUL GAP / TA -5.58% -14.17% -26.25% -9.50% -4.25% 0.00%
LIABILITY SENSITIVE INSTITUTION
Current Derivative / Option-Based Ideas for Asset Sensitive Financial Institutions
Asset Sensitive Financial Institution The “ASSET SENSITIVE” INSTITUTION The client is “asset sensitive”, and concerned that a stagnant, or declining rate environment will remain for some time
Investments 225,000 75,000 40,000 35,000 40,000 20,000 15,000
Loans 700,000 215,000 170,000 145,000 80,000 75,000 15,000
Other 25,000 25,000
Non-Mat Deposits 550,000 183,333 183,333 183,333
CD/FHLB 320,000 45,000 35,000 70,000 65,000 105,000
Capital from TruPS - Other Capital 105,000 17,500 17,500 17,500 17,500 17,500 17,500
TOTAL 1,000,000 270,833 235,833 270,833 82,500 122,500 17,500
Gap Analysis
GAP 94,167 (25,833) (90,833) 37,500 (27,500) 12,500 CUMUL GAP 94,167 68,333 (22,500) 15,000 (12,500) (0)
CUMUL GAP / TA 9.42% 6.83% -2.25% 1.50% -1.25% 0.00%
ASSET SENSITIVE INSTITUTION
Asset Sensitive Financial Institution Issue:
The client is “asset sensitive”, and concerned that a stagnant, or declining rate environment will remain for some time
Bank would prefer to maintain a more “neutral” or “less asset sensitive” A/L Gap position
Expected Transaction:
Solution:
Bank identifies Certain fixed rate FHLB borrowings to be hedged. Characteristics are as follows:
$20 Million
5 Years
FHLB Borrowing
Counterparty Fixed Rate
Bank 3MoL + Spread
Fixed R ate
Bank enters into a swap that synthetically converts the FHLB facility to floating rate
Bank “Receives Fixed”
Bank “Pays Floating”
Price Determination Issue:
Bank wishes to swap the interest rate on a FHLB borrowing to a floating rate
Bank
Result:
Bank converts its $20mm FHLB borrowing that is currently fixed at 4.05% to floating at 3-Month LIBOR + 130 bps.
5 Years $20,000,000 2.75% 3 Mo. Libor
Maturity date
Determine the appropriate term of the hedge
Bank would like to convert to floating for a term of 5 years
3-Month Libor is currently 2.32%
Subtract the 5 year swap rate from the “fixed rate” to determine the “Spread” that will be added to the 3 Mo. Libor index
New spread to 3-Month Libor =
(4.05% - 2.75%) = 1.30%
Fixed R ate
Sheet1
Gap Results The Result By swapping a specific FHLB facility to Libor-based floating, the institution becomes less “asset sensitive”
Investments 225,000 75,000 40,000 35,000 40,000 20,000 15,000
Loans 700,000 215,000 170,000 145,000 80,000 75,000 15,000
Other 25,000 25,000
Non-Mat Deposits 550,000 183,333 183,333 183,333
CD/FHLB 320,000 65,000 35,000 70,000 65,000 85,000
Capital from TruPS - Other Capital 105,000 17,500 17,500 17,500 17,500 17,500 17,500
TOTAL 1,000,000 290,833 235,833 270,833 82,500 102,500 17,500
Gap Analysis
GAP 74,167 (25,833) (90,833) 37,500 (7,500) 12,500 CUMUL GAP 74,167 48,333 (42,500) (5,000) (12,500) (0)
CUMUL GAP / TA 7.42% 4.83% -4.25% -0.50% -1.25% 0.00%
ASSET SENSITIVE INSTITUTION
Current Derivative / Option-Based Ideas
Scenario:
Borrower approaches your bank requesting a fixed rate facility…
Bank’s broader profile dictates a preference for floating rate loans.
How do I determine what fixed rate corresponds to our profitability requirements?
Swaps to Affect Loans
2. Now… Through the swaps marketplace…
determine the corresponding fixed rate
Swaps to Affect Loans Issue:
Bank has an increasing demand for fixed rate loans
Borrower requests a $10 million fixed rate loan with a maturity of 5 years
Bank would prefer to lend via floating rate
Bank Fixed Rate
$10 Million
5 Years
Bank Determines Appropriate Swap Structure
Bank enters into a swap that synthetically converts the loan facility to a floating rate
Bank “Pays Fixed”
Bank “Receives Floating”
Swaps to Affect Loans – Price Determination Issue:
Borrower requests a $10 million fixed rate loan with a maturity of 5 years
Bank
Borrower
Result:
Scenario: Client converts its $10mm loan that is currently fixed at 5.75% to 3-Month LIBOR + 300 Bps 5 Years $10,000,000 2.75% 3 Mo. Libor
Maturity date
Per internal pricing metrics, determine the appropriate floating rate spread
In this case., 3 Month Libor + 300 Bps
NOW…
Replace the 5 year swap rate for “Libor” in the equation to determine the corresponding fixed rate
3 Mo. Libor 2.75% + 300Bps = 5.75% FIXED RATE
Fixed Rate
Libor + Spread
Session 2
Methodology:
Understand and apply the index correlations
Utilize “Prime Flat” as the baseline for standardized fixed rate pricing
Loan Pricing – Facility Level Models
1. Utilize the term structure of Swaps to calculate a baseline
2. Now… determine the discount or premium spread to achieve goals
Loan Pricing – Facility Level Models
Anticipation of a Fed Move
Loan Pricing Theory Applied IMPORTANT NOTE ON SELECTING THE PROPER SWAP RATE:
** Must Consider “AVERAGE LIFE” of the Principal **
In Other Words:
If a facility is for 5 Years, but utilizes a 5 Year Amortizing Schedule…
The *Average life = 2.65 Years
Therefore, extrapolate the proper Swap Rate: 2 Yr Swap Rate = 2.63% 3 Yr Swap Rate = 2.70%
2.65 Yr Swap Rate (Extrapolated) = 2.67 - -- Equivalent Prime Flat Fixed Rate = 5.67% ---
*Average Life = “Weighted Average Time to Maturity” of a Series of Cashflows (Principal).
Yr 1 Yr 2 Yr 3 Yr 4 Yr 5 TOTAL 2,000 2,000 2,000 2,000 2,000 10,000
Lib Swaps Data
Libor vs 5 yr swaps
31-May-17
31-Dec-13
Sheet2
31-May-17
Swap Graph
Series Description
Rate paid by fixed-rate payer on an interest rate swap with maturity of five year.
Unit:
Multiplier:
Currency:
Swap Summary - Evals
Liquidity Risk
Loan Cap Example
3 Mo Libor
Corridor Graph
Fixed Rate Equlv
Determine Swap Rate
3 Mo Libor
3 Mo Libor
Dollar Cost
7 Years
7 Years
7 Years
7 Years
7 Years
7 Years
7 Years
($250K / 7 / $10 Mln) = .0036 = .36%
&F
0.88%
0.88%
0.88%
125000
Spread:
3.00%
Spread:
3.00%
Spread:
3.00%
7
* Additional Cap Spread:
($125K / 7 Years / $5 Mln) = .0036 or .36%
The Initial rate is Lib3M + 3.00%... or 3.88%. There is no cap in this example and is illustrated for comparitive purposes.
In this example, the loan structure initally floats at 3 Mo. Libor plus 3.00% (currentky 3.88%). The "Cap" is associated with the 3 Mo. Libor index only. By incorporating the Cap, we limit the 3 Mo. Libor index from going above 2.00%. The net effect of the facility is that it floats at lower rates... Once 3 Mo. Libor exceeds 2.00%, the rate is "capped" at an all-in level of 5.00%. The up-front fee for structure is $125K.
In this example, the loan structure initally floats at 3 Mo. Libor plus 3.36% (currently 4.24%). The "Cap" is associated with the 3 Mo. Libor index only. By incorporating the Cap, we limit the 3 Mo. Libor index from going above 2.00%. The net effect of the facility is that it floats at lower rates. Once 3 Mo. Libor exceeds 2.00%, the rate is "capped" at an all-in level of 5.36%. There is no fee for this structure.
Period
Pertinent Rates
Fed Target
Prime- FLAT
Rate equivalent
2 Yr
Pertinent Rates
Fed Target
Prime- FLAT
Rate equivalent
2 Yr
2.80%
1
2
3
4
5
15
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1 Years Worth of Volatilities – 5 Year Swap
5 Yr Maturity
Interest Rate Caps
The seller of the Cap makes a payment to the buyer when the short-term benchmark index rate (e.g. LIBOR) exceeds the Cap strike rate.
If the index is equal to or below the “strike rate” of the Cap, there is no payment.
If index rate is greater than the cap strike rate, buyer receives a payment from seller,
Payment is equal to the rate differential on the contract amount over the number of days in that period.
The upfront premium is determined primarily by the following factors:
Contract Notional Amount Theoretical dollar amount to be protected
Tenor Term of the insurance contract
Strike Rate The index rate that when exceeded, payments are remitted
Implied Rate Volatility high volatility = high cost
Shape and steepness of the swap curve The steeper the swap curve = The higher future Libor expectations = Higher cost
Interest Rate Cap Mechanics The cap functions as an interest rate insurance policy. In exchange for a one-time, up-front payment, the counterparty agrees to compensate the purchasing bank for the increment that the Index Rate rises above a chosen level (“the strike rate”).
4.50%
5.00%
5.50%
6.00%
6.50%
7.00%
7.50%
8.00%
8.50%
1 2 3 4 5 6 7 8 9 10 11 12 13
Cap Rate Rate Paid Potential Rate Scenario
Payment to Cap Buyer
For informational Purposes Only
A Typical CAP Transaction Sample of Upfront premiums for certain structures
Based on $10 Million Notional Pricing as of June 1st, 2018
Caps to Affect Obligations
Scenario:
Borrower approaches your bank requesting a fixed rate facility…
Bank’s broader profile dictates a preference for floating rate loans.
Bank is looking for products to differentiate from the competition.
Possible Solution:
Caps to Affect Loans
1. Offer a floating rate - with a cap or “ceiling” on the borrower’s rate
2. Now…
Through the caps marketplace…
Determine the cost of the cap, and how to pass this cost
on to the borrower
Caps to Affect Loans
For informational purposes only.
1.00%
1.50%
2.00%
2.50%
3.00%
3.50%
4.00%
4.50%
5.00%
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18
Rate Scenario Purchased Cap Strike Sold Cap Strike
A cap “corridor” structure is a collaboration of two separate and distinct cap transactions. The bank purchases a cap at a strike level close to current rates. The bank simultaneously sells a cap back to the counterparty with a strike rate at a level where the initial cap economics are no longer beneficial. The net result allows for affordable protection for the bank during the initial stages of a rising rate environment.
Net Cap Economics
Facility NET
Chart3
Data
Year
1
2
3
4
5
6
7
8
9
10
11
12
13
Libor vs 5 yr swaps
1-Jun-16
31-Dec-13
Swap Graph
Prime vs Libor
Series Description
Rate paid by fixed-rate payer on an interest rate swap with maturity of five year.
Unit:
Multiplier:
Currency:
Caps
Scenarios
Yr
Fixed
Float
1
2.00%
0.30%
2
2.00%
0.71%
3
2.00%
1.12%
4
2.00%
1.53%
5
2.00%
1.94%
6
2.00%
2.36%
7
2.00%
2.77%
8
2.00%
3.18%
9
2.00%
3.59%
10
2.00%
4.00%
3.70%
0.0041111111
Scenarios
Fixed
Float
Corridor Graph
Fixed Rate Equlv
3 Mo Libor
Prime
3 Mo Libor
3 Mo Libor
Dollar Cost
7 Years
7 Years
7 Years
7 Years
7 Years
0.25%
0.25%
0.25%
235000
Spread:
3.00%
Spread:
3.00%
Spread:
3.00%
7
* Additional Cap Spread:
($235K / 7 Years / $5 Mln) = .0067 or .67%
The Initial rate is 3.25%. There is no cap in this example and is illustrated for comparitive purposes.
The Initial rate is 3.25%. The "Cap" is associated with the 3 Mo. Libor index only. In this example, the loan structure is floating at 3 Mo. Libor plus 3.00% (currentky 3.25%). By incorporating the Cap, we limit the 3 Mo. Libor index from going above 2.25%. The net effect of the facility is that it floats at lower rates. Once 3 Mo. Libor exceeds 2.25%, the rate is "capped" at an all-in level of 5.25%. The up-front fee for structure is $235K.
The initial Rate is 3.92%. The "Cap" is associated with the 3 Mo. Libor index only. In this example, the loan structure is floating at 3 Mo. Libor plus 3.67% (currently 3.92%). By incorporating the Cap, we limit the 3 Mo. Libor index from going above 2.25%. The net effect of the facility is that it floats at lower rates. Once 3 Mo. Libor exceeds 2.25%, the rate is "capped" at an all-in level of 5.92%. There is no fee for this structure.
Period
Pertinent Rates
Fed Target
Prime- FLAT
Rate equivalent
2 Yr
Pertinent Rates
Fed Target
Prime- FLAT
Rate equivalent
2 Yr
2.82%
1
2
3
4
5
15
MBD00A9276C.xls
Chart5
0.0025
0.02
0.0325
0.005
0.02
0.0325
0.01
0.02
0.0325
0.015
0.02
0.0325
0.0215
0.02
0.0325
0.0275
0.02
0.0325
0.035
0.02
0.0325
0.0425
0.02
0.0325
0.045
0.02
0.0325
0.0425
0.02
0.0325
0.035
0.02
0.0325
0.0275
0.02
0.0325
0.0215
0.02
0.0325
0.0175
0.02
0.0325
0.0125
0.02
0.0325
0.0075
0.02
0.0325
0.005
0.02
0.0325
0.0025
0.02
0.0325
Notional Size
Amortization Schedules
Rate Variables
Start Date
End Date
Early Exit
Forward Dating Forward-starting swaps to lock in the rate today for a “Start Date” in the future.
A bank may commit to a facility with a closing date in the future, and can structure a swap to hedge the transaction with today’s levels.
Forward-starting swaps allow banks to take advantage of favorable rates when the market offers them - not just when coming to market.
Bank may have a swap currently on the books that matures in one year
Bank determines that rates are set to rise prior to the maturity of the legacy swap
Bank enters into a “Forward Dated” swap to continue the hedge
- Transaction takes into account today’s levels for start in the future
- A “premium” in the form of a higher rate is paid for consideration of the forward date
Swaps / Options - Customization
Blend/Extend A common restructuring technique for existing interest rate swaps is to amend the
characteristics through the “blend and extend” strategy.
This encompasses rolling in the present value of an existing trade into the rate and maturity of a new deal.
Bank determines that current rates are significantly lower than legacy swap fixed rate
Bank rolls the “Underwater” mark of the current swap into a new transaction with longer maturity
- The result is an immediate lower rate (although still “out of the money”.)
Swaps / Options - Customization
Documentation
The ISDA Doc Set
ISDA – International Swap Dealers Association In 1984, standardization of the swaps market began when 18 dealers came together to develop “Standardized” terms for Interest rate swaps. This resulted in the formation of the International Swap Dealers Association (ISDA) in 1985.
The group created the first addition of the Code of Standard Wording, Assumptions and Provisions for swaps.
In 1987, an “ISDA Master Agreement” was developed which standardized the basic tenets for participating in the swaps market, including:
•Wording of contracts
•Setting of rates
•Calculation of amounts
3 Parts to the ISDA Doc Set
• The ISDA Master Agreement The ISDA Master Agreement is the standardized portion of the document that spells out all of the global rules and variables related to the swaps market
• Schedules to the Master Agreement The customized portion of the agreement. This section lays out specific terms and conditions of the transaction between the two parties. This may include additional default language, assign-ability clauses, additional cross-collateralization terms, etc.
• Credit Support Agreement (CSA) A CSA defines the terms and rules under which collateral is posted or transferred between swap counterparties to mitigate the credit risk arising from "in the money" derivative positions.
Documentation
Components of the CSA Collateral Variables to the CSA agreement.
Independent Amount Used with “unilateral” CSA agreements - Less applicable with implementation of Dodd / Frank Required to be pledged as long as there are outstanding obligations between the Bank and counterparty Is the additional collateral required above the net derivatives exposure
Minimum Transfer Amount Minimum amount for the exchange of collateral When a party’s exposure exceeds the sum of the posted collateral, the amount that must be met before a transfer of
additional collateral is required When a party’s exposure is less than the sum of the posted collateral, the amount that must be met before a return of
the collateral is required
Threshold Represents an unsecured dollar level of mark-to-market exposure above which collateral must be posted Often dependent on the credit quality of the party and may be set to vary depending upon the credit rating as well as
the party’s financial health Customer is required to post collateral when the MTM exceeds the threshold amount
Collateral Scenario A Bank executes a $10mm, 5-year pay-fixed swap:
CSA Terms: o Independent Amount: $0 o Threshold Amount: $100,000 o Minimum Transfer Amount: $50,000
Scenario A: Bank’s swap is in-the-money by $75,000
Neither party is in-the-money by less than the threshold amount No collateral is required to be posted to you by you or your counterparty.
Scenario B: Bank’s swap is out of-the-money by $75,000
Bank’s negative position does not exceed the Threshold Amount No collateral is required.
Collateral Scenario - Continued A Bank executes a $10mm, 5-year pay-fixed swap:
CSA Terms: o Independent Amount: $0 o Threshold Amount: $100,000 o Minimum Transfer Amount: $50,000
Scenario C: Bank’s swap is out-of-the-money by $125,000
Bank’s negative position exceeds the Threshold Amount by $25,000 However, it is not enough to trigger the Minimum Transfer Amount. No collateral posted.
Scenario D: Bank’s swap is out-of-the-money by $250,000
The Bank is required to post $150,000 of collateral This is the negative value in excess of the Threshold Amount.
Risks
Like most any earning asset or interest bearing liability, interest-rate swaps encompass a whole new set of risks that must be addressed:
Basis
Liquidity
Basis Risk
Basis risk is the potential exposure to the difference between the floating rate on the variable rate hedged facility and the floating rate received from the swap counterparty. (i.e. hedging a loan tied to PRIME with a swap tied to 3MO LIBOR.)
Correlation - Prime Vs. Libor Basis Risk
0.00
1.00
2.00
3.00
4.00
5.00
6.00
7.00
8.00
9.00
10.00
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understanding and managing option risk - gsb

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