ISDA Section 04 Valuing Unwinding and Hedging Swaps
ISDA Section 04 Valuing Unwinding and Hedging Swaps
ISDA Section 04 Valuing Unwinding and Hedging Swaps
David Mengle
Vice President
J.P. Morgan Securities Inc.
Basic principle of financial instrument valuation
Forward curve
- Yields expected to prevail in future periods
- Used to estimate expected floating-rate payments
Yield curves
Forward rates
ZC Rates
f'ah
Rates Yields
Maturity
Zero coupon rates
Present value of coupon bond cash flows = Present value of zero coupon cash flows
The zero-coupon yield curve is derived from the coupon bond yield
curve by the 'bootstrapping' process
- Coupon bond cash flows can be divided into series of zero coupon bonds for
each year.
- Bootstrapping involves solving for a set of zero coupon rates that satisfy the
no-arbitrage conditions.
The par bond yield curve implies a set of zero coupon rates
Maturity \ YieM
1 Year 6.12 %
2 Year 6.52 %
3 Year 6.72 %
4 Year 6.87 %
-
Year 2 cash flow must be $93.86. What 2-year zero-coupon rate produces this present value?
Answer: 6.53%, which can now be used to discount Year 2 cash flows.
Repeat step for each year. Resulting zero coupon rates on next page
Where do forward rates come from?
No-arbitrage conditions
$106.00
What ~ n e - ~ erate,
a r one
year from now (1 2x24
forward rate), would make
6.00% $106.00 grow to $1 14.49?
X..XX% = 8.01%
= RlZxz4
For example, investing at 6.53% for two years should produce the
same result as investing for one year at 6.12% and reinvesting at
6.95%.
Pricing a swap
You pay fixed
rate
Forward rates used to estimate
expected future floating payments forward curve
.,., .., ..
What happens when rates change
rate
Assume interest rates rise
Forward curve shifts upward
But swap rate remains fixed
Par (market rate) swap: fixed rate
So floating rates increase, but the fixed rate stays constant. What is
the net present value (or "mark to market value") of the swap now?
Marking the swap to market
You pay fixed
Fwd Floating Fixed Fixed
- -
ZC
Mat. Period -
Fwd P-ent -
PV Coupon Payment -
PV
&*a
16
What are the potential sources of value in a
derivatives transaction?
Portfolio management
INPV reflects the difference between the credit risk adjusted rate on the
transaction and the prevailing mid-market rate
Understanding INPV: Example
Probabilities
- Degree of belief (30% chance of rain)
- Relative frequency (5% of students fail)
Properties of probabilities
- Each probability must be a non negative fraction
- Probabilities for all possible random events must sum to
one <
Events
- Mutually exclusive
.. - Independent - 2 -#& & L k ? - M W -,&~aof&
Normal distribution
Distribution associates random events with probabilities'
-
Distribution
.
suggests 20%
probability of
Probability observing -1.3
-3.0 -2.5 -2.0 -1.5 -1.0 -0.5 0.0 0.5 1.0 1.5 2.0 2.5 3.0
Outcome
Statistical measures
Dispersion
- Variance (02) is average of squared deviations of potential outcomes from
mean, weighted by probability
- Standard deviation (o) is square root of variance
Time aggregation: Annual s = (Daily o) x SQRT(day count)
Interaction
- Covariance (o,,) measures how much two random variables move together
Intrinsic value C W
- Amount option would pay out if exercised immediately, that
IS ...
- Amount by which option is in the money
Price
Out of
the In the
money money
Determining option value
Present value of expected in-the-money cash flows
TIMES
- Expected underlying price, GIVEN that option expires in the
money, MINUS strike price
TIMES
- Discount factor
Numerical solutions
- Approximate value through computation &&a&m
- Binomial tree
Simulation
- Monte Carlo simulation
- Calculate value from a set of randomly-generated price
scenarios
Derivatives
Assignment
- A counterparty transfers to another counterparty his rights and
-
Termination
An agreement to extinguish the original swap obligation.
-
-
&5 1% M
'I/,&
Offsetting swaps
- Entering an "opposite" swap, which offsets the original position
Unwinding a swap: Offsetting swaps
Period 1
c ~ n n ,
- J.4U70
4
Investor $100 million notional Dealer
T.IROR
*
Period 2 (rates fall 10 bps over next day)
LlBOR + 10
5.40%
*
Derivatives
-
Hedging interest rate swaps
Execute offsetting swap - ~&~ibdt& or- M? &,q7 &A?-
-
-
LIBOR LlBOR
W Interdealer
Counterparty Dealer
< market
Fixed Rate (5.4%) Fixed Rate (5.5%)
*
E US$ Loans
$100 million
DM 180 million
6 8%
I
German Bank
-
a
4
Initial principal exchange
6.1% (US$)
b
v
Dealer
4.8% (DM)
A
Payments during swap
4.8%
Final principal exchange
r
US$100 million
D M Note DM 180 million
A cross-currency swap can be managed as three
separate risk components
Each risk is highly liquid, so product liquidity is not important
3-month
.................. ..................
currency *..................
3-month 3-month
DEM Libor DEM Libor
+ 10
Definition
- The uncertainty that results from changes in the relationship
Counterparty
- Fixed rate
Market
Basis risk arises when swap payment dates do not correspond exactly to
Eurodollar settlement dates
Maturity
; ,.,
Curve risk arises from non-parallel shifts of
the yield curve
Example: U.S. dollar 1993 - 1994
6 -
5 -
4 -
3 I I I I I I I I I I I I I I I
3mo 1 2 3 4 . 5 6 7 8 9 10 12 20 25 .30
Maturity
Spread risk
Definition
- The uncertainty that results from changes in the difference between
Option value
Option value
I
Actual value
Libor
4
Interest rate
Counterparty - 4 Dealer
swap
Max (L-Strike,O) b
Swap Rate
Counterparty 4
Market
Max (L-Strike,O)
-4
Max (Strike - G,O)
Dealer
. Libor
b
Short sale of
gold
Lease rate
-
...but, how large a short sale?
market
Max (Strike - G,O)
Ganima risk means that a significant move in underlying markets can leave a
positioi~underhedged or overhedged, either of which is costly
At-the-money options are the most difficult to delta hedge because they have
high gamma
- High gamma means small changes in underlying price have large effects on
probability of exercise (delta)
- This effect becomes especially pronounced just prior to expiry
- Market gapping
What influences the value of an option?
The "Greeks"
Implied volatility
- Measure of uncertainty about future underlying price
implied in market price of option
- Not observed directly
Underlying price -+ 1 I
Strike price -+
Time to maturity -+
option + (Implied) option price
Discount rate -+
model
Historical volatility -+ I I
Using option pricing model to solve for implied volatility:
Underlying price -+
Strike price -+ Option pricing
Time to maturity + + Implied volatility
Discount rate +
model
Observed option price +
Volatility risk
David Mengle
Vice President
J.P. Morgan Securities Inc.
How a deal gets done
Where do you fit in?
Organization structure
Trader
- Request firm prices
Credit
- Ensure proper line in place or obtain credit approval
Legal
- Ensure documentation in place
Operations
- Ensure confirmation went out
Front office: Trader or portfolio manager
Responsible for ...
Alternative approaches
- Preapproved lines
- Case-by-case authorization
Back office
Monitor collateral
Investigation of problems
Trade processing
Two types
Event-driven
Two types
Event-driven Periodic (Trade maintenance)
Termination/maturity Amortization
Result in ... Payments (recurring)
Data capture (deal forms) Collateral revaluation
Confirmations Polling dates
Premiundfee payments Payments and confirmations and
accounting entries plus . ..
Principal exchanges
Collateral exchanges
Accounting entries
-
12
Corporate risk management
r
Responsible for...
Management information
- Gathering position and risk information
- Assembling risk reports for senior management
- Limits
- External regulations
So where do we all fit in?