yield curves &corporatefinance - university of...
TRANSCRIPT
Yields, Swaps,
& Corp Fin
Paul Laux
Teaching thoughts
Yield curves
Swap pricing
Corporate finance
More teaching
thoughts
Yields, Swaps,& Corporate Finance
Financing Tactics Teaching with Bloomberg
Paul Laux
Exelon Center Finance Labs Conference
University of Delaware
August 2013
Yields, Swaps,
& Corp Fin
Paul Laux
Teaching thoughts
Yield curves
Swap pricing
Corporate finance
More teaching
thoughts
Gratitude
Thanks, Rich, for our Conference.
Thanks to all of you for the opportunity toshow you some of my teaching ideas.
Yields, Swaps,
& Corp Fin
Paul Laux
Teaching thoughts
Yield curves
Swap pricing
Corporate finance
More teaching
thoughts
Stage setting
The teaching application I have to share is froman undergraduate capstone course, “AdvancedCorporate Finance.” As a capstone, the pointis to integrate the students’ prior learning andsend them on their way to apply it. Especially,the course links financial markets to corporatefinance applications. This applicationspecifically links yields and interest rates toswaps to corporate financing opportunities.
Yields, Swaps,
& Corp Fin
Paul Laux
Teaching thoughts
Yield curves
Swap pricing
Corporate finance
More teaching
thoughts
Outline
1 Teaching thoughts
2 Yield curves
3 Swap pricingSwap Manager introThe value of fair value
4 Corporate financeBenchmarking borrowing costsApplication to fixed rate loans
5 More teaching thoughts
Yields, Swaps,
& Corp Fin
Paul Laux
Teaching thoughts
Yield curves
Swap pricing
Corporate finance
More teaching
thoughts
Thoughts on a teaching approach
Never miss the chance to reinforce andlink the basics to practice; “Everything Ineeded to know I learned in...”
Example:Yield curves poster—assigned aspre-work, review in a prior class or podcast
Bloomberg analytics apps build financeconcepts into practical form, e.g., as inSwap Manager for swap pricing
The details can be a bit intense, but alsoopen doors for extended study later
Markets solve problems...interest rate andswap markets solve corporate financeproblems
Market information is of practical help evenfor those who may never transact in thespecific market
Yields, Swaps,
& Corp Fin
Paul Laux
Teaching thoughts
Yield curves
Swap pricing
Corporate finance
More teaching
thoughts
The big picture of yield curves...... reinforcing and extending with little pictures: see paper poster... can’t use swaps unless can use interest rate reasoning
Swap curves: Plain vanilla interest rate swaps promise the periodic payout (or receipt) of a floating rate cash flow (often at a LIBOR rate) in return for the periodic receipt (or payout) of a fixed rate cash flow. The fixed interest rate used to compute the fixed rate receipt is called the "swap rate." The swap rate is what market participants bargain about, as it sets the present value of the swap. Eyes-wide-open bargaining will lead to a swap with zero NPV at the start. Later, as interest rates change, one party will tend to win or lose as the NPV rises or falls, and the swap becomes "off market" rate.
The curves below are swap curves, showing swap rates for plain vanilla swaps of different tenors (or lengths of agreement). In these swaps, the exchanges happen semi-annually. Two swap curves are shown--one relative to EUR LIBOR (with payments in EUR), and one relative to USD LIBOR (with payments in USD). The Treasury curve is shown for comparison.
Swap curves depend on both spot and forward curves. They depend on spot curves because future cash flows must be discounted to determined their value---a job for which spot curve rates are well suited. They depend on forward curves because the future payments on the floating leg depend on future interest rates---and forward curves give us a sense for expected future interest rates.
Understanding yield curves, with help from Bloomberg.
Bloomberg's curve finder -- type CRVF <Go> -- provides access to a long list of yield curves. you can search by keyword, or lookup by country. Bloomberg refers to the curves by ID number. Prominent curves are the I25 US Treasury yield curve, and the S23 US dollar denominated swaps curve (of which more elsewhere on this page). When you know the curve you want, one way to get started with it is to type GC <Go>, for "Graph curves." You can then enter the ID number of the curve that interests you, and obtain a chart. The rest of this page is to help you understand some of the key yield curves you will want to use.
This GC graph shows the I25 Treasury "actives" yield curve, which has coupon-paying T bond YTMs. The chart also shows the yield curve for Treasury Strips. A Treasury Strip is a pure-discount (zero-coupon) bond version of a TBond, with only one cash flow, at maturity time. The Strips curve is one case of a spot curve. One way to think about a coupon bond is that it is really a collection of strips or zeros, engineered to have just the right payouts at each time.
The bottom panel shows the spread between the Strips curve and the Treasury actives curve. The spread is always positive. This will always be the case for an upsloped coupon curve. The reason is that the coupon curve is really an average of the spot curve elements for all dates up to the maturity, since the coupon bonds has cash flows at all those dates. The near-in dates have spot curve yields that are lower than the ones that are further out in maturity.
The snapshots on this page were taken in March 2013.
The green lower curve is the I25 Treasury actives coupon paying curve. The blue upper curve is the I39 US Strips curve.
From spot curves to implied forward rates of interestThe forward curve matrix: Type FWCM <Go>, and specify a curve family, like I23 US Treasury Actives, US Treasury coupon-paying bonds.
The chart shows several snapshots of the "forward curve." In order, from top to bottom, they are from 10 years ago (white), 5 years ago (green), 1 year ago (blue, barely visible) and Mar 2013 (now or 'spot'--meaning the spot time not spot curve). Interest rates have been falling all decade long!
Note that the implied forward curves are all upward sloping. That suggests that, at each date, the economy has expected interest rates for specific periods farther into the future to be higher than for periods closer to the present. Of course, the succession of curves (each one lower than the previous one) says it has not turned out that way. If the Fed controls rates with monetary policy and QE, this suggests their actions have been unanticipated. Or perhaps market forces, which are harder to anticipate, have been more important.
The green top curve is the S23 USD swap curve. The red curve usually in the middle is the I25 coupon Treasury curve. The blue curve at the bottom is the S45 EUR swap curve.
The bottom panel shows interest rate differential between the various curves. In this picture, the US swap curve is subtracted from each of the other curves. S23 - I25 would be called the "swap spread," so Bloomberg's red curve (shown by default--I made no special choices on this GC screen) is the negative of the swap spread. (Also note that red and blue have different meanings in the top panel vs. the bottom.)
Swaps are usually quoted for a AA credit situation. Thus it may seem natural that USD swap rates are higher than Treasuries. But it needn't be like that, as there are additional considerations. For example, at the long end of the curve, the USD swap rate is lower (the swap spread is negative). Since the swap rate is paid in return for a floating rate, that suggests that market participants expect the floating rate to be quite low, or else that there is low liquidity on the fixed pay side of the market at the long end (allowing fixed rate payers to get a better deal).
Details of the recent shape and changes in the USD swap curve (at left) and EUR swap curve (above). The long end of the USD swap curve has been steepening slightly lately, suggesting that long term fixed payments are being seen as somewhat less valuable relative to floating rate payment (i.e., so the market requires larger fixed payments to make a fair deal).
Questions or comments? Paul Laux, Department of Finance, [email protected]
What are spot curves useful for? When you know the yield off the spot curve, you know how to form the present value of a dollar received at that date. Just form the discount factor (i.e., (1+SpotYield)^-N). If the curve is for riskless bonds, the PV is for a risk free dollar. If the curve is for, e.g., AA bonds, then the PV is for a dollar with that riskiness.
What else are spot curves useful for? They are the observed rates from which forward rates of interest can be calculated. Forward rates give insight into the future rates of interest that market participants expect. See the next section for more on this (up and to the right).
The EUR swap rate is generally lower than the USD swap rate, suggesting that payments at that fixed rate in EUR are regarded as quite desirable. One possible reason, just as an example, would be if the USD floating rate is expected to track higher more than the EUR floating rate, making it more attractive (higher demand) to fix payments in EUR terms.
Yields, Swaps,
& Corp Fin
Paul Laux
Teaching thoughts
Yield curves
Swap pricing
Swap Manager intro
The value of fair value
Corporate finance
More teaching
thoughts
Next: Bloomberg Swap ManagerStart with 5-year plain-vanilla interest rate swap.
Type SWPM <Go> to enter Bloomberg's "Swap Manager" facility. Pricing rooted in present values of cash flows forecasted using OIS swap rates as the basis for discount rates and forecasting cash flows based on cash/futures interest rates and yield curves. Three screen regions (red boxes) show each counterparty (leg) details and market pricing.
Zero premium indicates semiannual USD fixed coupon at 1.778% pa over 5 years is market-value-equivalent to quarterly USD LIBOR floating (recently at 0.263% pa)
Yields, Swaps,
& Corp Fin
Paul Laux
Teaching thoughts
Yield curves
Swap pricing
Swap Manager intro
The value of fair value
Corporate finance
More teaching
thoughts
Cross-currency basis swapsA basis for making cost of finance comparisons across currencies
SWPM can also value cross-currency basis swaps (float-float swaps across two currencies). Use PRODUCTS pull-down menu to chose this swap.
Quarterly- reset quarterly-pay 5-year x-crncy basis swap across USD-EUR has zero premium for deal to receive USD LIBOR and pay EUR LIBOR minus a 23 b spread. Market conditions are USD LIBOR at 26.310 bp and EUR LIBOR at 22.6bp pa.
Yields, Swaps,
& Corp Fin
Paul Laux
Teaching thoughts
Yield curves
Swap pricing
Swap Manager intro
The value of fair value
Corporate finance
More teaching
thoughts
This is useful info...and not only forswap counterparties
• Usefulness: If I’m a treasurer with aborrowing need, this analysis tells me whatinterest rate in someone else’s currency is agood deal in my currency• Claim: Borrowing five years floating atsemiannual USD LIBOR is the same as cost offinancing as borrowing five years floating atquarterly EUR LIBOR minus 23 bp• Evidence for claim: One can be swapped intothe other, with zero premium paid/received...azero NPV trade
Yields, Swaps,
& Corp Fin
Paul Laux
Teaching thoughts
Yield curves
Swap pricing
Swap Manager intro
The value of fair value
Corporate finance
More teaching
thoughts
Swap manager is flexible...... to deal with various deals. Here is an annual pay swap.
Use pull-downs to change reset and pay freq to "Annual".
At annual reset and pay frequency, the -23 bp spread results in an "off-market" premium swap, with a positive market value of 0.5955 bp, i.e. $5954 per $10 million of notional principal.
Yields, Swaps,
& Corp Fin
Paul Laux
Teaching thoughts
Yield curves
Swap pricing
Swap Manager intro
The value of fair value
Corporate finance
More teaching
thoughts
The fair-value annual swapAsk SWPM to calculate EUR LIBOR spread for zero premium. The at-market swap has a spread of -21.81 bp pa. Comparing to the quarterly EUR LIBOR case, increasing the rate paid to the EUR LIBOR leg a little reduces the PV of the deal to the USD LIBOR paying leg, so it is no longer positive.
Yields, Swaps,
& Corp Fin
Paul Laux
Teaching thoughts
Yield curves
Swap pricing
Swap Manager intro
The value of fair value
Corporate finance
More teaching
thoughts
Behind the scenes...Curves, cash flows, and valuation scenarios are on the SWPM tabs
Yields, Swaps,
& Corp Fin
Paul Laux
Teaching thoughts
Yield curves
Swap pricing
Swap Manager intro
The value of fair value
Corporate finance
More teaching
thoughts
BB help docs provide pricing andkey-punch details... green help key explains a lot of the finance I am skipping over
Yields, Swaps,
& Corp Fin
Paul Laux
Teaching thoughts
Yield curves
Swap pricing
Corporate finance
Benchmarking
borrowing costs
Application to fixed
rate loans
More teaching
thoughts
What’s it got to do with corp fin?If I’m a treasurer with a borrowing need, this analysis can tell us whatinterest rate in someone else’s currency is a good deal in my currency.
hhType XCF, for pictorial cross-currency basis swap premium analysis. Choose single currency analysis from Views pulldown, EUR (vs USD LIBOR) and 5 year term. Note results show spreads for a zero premium at various dates (including Today). Note this is bid view, i.e., the leg receives USD LIBOR.
Recall -23 bp is same spread we say with quarterly reset in earlier detailed analysis---numbers here are result of same analysis.
Yields, Swaps,
& Corp Fin
Paul Laux
Teaching thoughts
Yield curves
Swap pricing
Corporate finance
Benchmarking
borrowing costs
Application to fixed
rate loans
More teaching
thoughts
USD vs EUR LIBOR floating ratesA lower EUR rate is PV-equivalent to a higher USD rate. Di↵erentiallevel at 22-23 bp for maturities of 2+ years; was 45-ish bp last year.
Same analysis (XCF <Go>), but now choose more maturities and mid-point quotes. We are moving toward a full comparison of financing opportunities in dollars and euros, from the point of view of a US based treasurer. The x-crncy basis swap market tells us what spread (EUR LIBOR differential vs USD LIBOR) would make for an at-market swap today---thereby telling us what would be an at-market deal comparison on floating rate loans.
Today's market is the rightmost set of bars, with history to the left.
Today's market, for various maturities
Yields, Swaps,
& Corp Fin
Paul Laux
Teaching thoughts
Yield curves
Swap pricing
Corporate finance
Benchmarking
borrowing costs
Application to fixed
rate loans
More teaching
thoughts
Can view info in various formats...... to answer various questions; e.g., a yield curve view helpstreasurer evaluate floating rate loan comparisons of various terms
Yields, Swaps,
& Corp Fin
Paul Laux
Teaching thoughts
Yield curves
Swap pricing
Corporate finance
Benchmarking
borrowing costs
Application to fixed
rate loans
More teaching
thoughts
Analyze x-crncy fixed rates too... by snapping on same-currency fixed-for-floating swap to each leg... remember, swap manager prices those too
And USD LIBOR floating is PV-equivalent to EUR LIBOR - 23 bp. So if treasurer with a 1.77% fixed USD borrowing opportunity can beat EUR LIBOR - 23 bp, it is a good deal (in PV terms; appropriate-for-the-use is a different question). To compare to a fixed rate EUR loan, snap a EUR fixed-for-floating swap onto this analysis.
Here is the USD side of the analysis. We have seen both these SWPM screens before. On left is a USD fixed-for-floating swap. On right is a USD-EUR LIBOR floating-floating swap (cross-currency basis swap).
1.78% fixed is PV-equivalent to USD LIBOR floating (i.e., with timing details as shown).
Yields, Swaps,
& Corp Fin
Paul Laux
Teaching thoughts
Yield curves
Swap pricing
Corporate finance
Benchmarking
borrowing costs
Application to fixed
rate loans
More teaching
thoughts
Not a fantasy... research has established that searching for good fundingopportunities this way is profitable for AA-rated credits... Journal of Financial Economics 86 (2007), 145-177
Yields, Swaps,
& Corp Fin
Paul Laux
Teaching thoughts
Yield curves
Swap pricing
Corporate finance
More teaching
thoughts
Teaching tactics
• This sort of thing works best hands-on—butpound the points, as students will want to losethe forest for the trees• My favorite routine: See one, do one, teachone• Force more than is comfortable: Detailed,graphical briefing books; recordings; class labexercises• Better for depth than breadth; takes a lot oftime
Yields, Swaps,
& Corp Fin
Paul Laux
Teaching thoughts
Yield curves
Swap pricing
Corporate finance
More teaching
thoughts
The end. Thank you for your timeand e↵ort!
That’s all I know about Bloomberg and mostof what I know about fixed income.
Questions?