Development of IR swaps market

1. Development of IR swaps market Roman Androsov

2. Development of IR swaps market • How IR swaps market started. • Where it is now. • What determined its growth.

3. Development of IR swaps market • How IR swaps market started. • Where it is now. • What determined its growth. • How IR swap market evolved: - role of the intermediary; - swap documentation; - secondary market;

4. Development of IR swaps market • How IR swaps market started. • Where it is now. • What determined its growth. • How IR swap market evolved: - role of the intermediary; - swap documentation; - secondary market; • Types of IR swaps, swaptions, caps and floors.

5. How IR swaps market started. • In the late 1970’s, increasing levels and volatilities of IR led financial institutions to seek a way to offset IR risks.

6. How IR swaps market started. • A market response to the increased need to hedge IR risk exposure was the introduction of IR futures (FRA’s), options and swaps.

7. How IR swaps market started. • The first IR swap was developed in 1982, when the SLMA (Sallie Mae) executed a fixed-for-floating swap deal.

8. How IR swaps market started. • The first IR swap was developed in 1982, when the SLMA (Sallie Mae) executed a fixed-for-floating swap deal. • IR swaps become a popular vehicle to manage IR risk: recent data:http://www.bis.org/publ/otc_hy0505.pdf

10. What’s behind the growth?

11. What’s behind the growth? • Initial motivation: credit arbitrage opportunities • quality spreads between fixed-rate and floating-rate US debt markets • were frequently not equal; • -quality spreads between US debt markets and Eurodollar bond markets were often not the same too;

12. What’s behind the growth? • Initial motivation: credit arbitrage opportunities • quality spreads between fixed-rate and floating-rate US debt markets • were frequently not equal; • -quality spreads between US debt markets and Eurodollar bond markets were often not the same too; • Comparative advantage principle: although a borrower with a strong credit has a cost advantage over a borrower with a weaker credit in both markets, but may have a comparative advantage in one them; such a borrower may borrow in this market and swap IR payments with the other borrower who, naturally, has a comparative advantage in the other market. The difference in quality spreads is divided between the parties to the swap, making both parties better off

13. Comparative advantage principle Cost of borrowing IR AA Floating AAA 30 Time 0 1 2

14. Comparative advantage principle Cost of borrowing IR AA Fixed AAA AA Floating AAA 30 Time 0 1 2

15. Comparative advantage principle Cost of borrowing IR AA Fixed Δfix RAAA AAA AA Floating Δflt AAA Libor+rAAA 30 Time 0 1 2 t

16. Comparative advantage principle: Δfix > Δflt Fixed-rate market Floating-rate market Libor+rAAA+ Δflt RAAA AAA AA

17. Comparative advantage principle: swap payments Fixed-rate market Floating-rate market RAAA Libor+rAAA+ Δflt AAA AA Libor+rAAA-pAAA RAAA+Δfix -pAA Libor+rAAA+ Δflt RAAA Intermediary

18. Comparative advantage principle: role of the intermediary Fixed-rate market Floating-rate market RAAA Libor+rAAA+ Δflt AAA AA Libor+rAAA-pAAA RAAA+Δfix -pAA Libor+rAAA+ Δflt RAAA Intermediary pI =-(pAAA+ Δflt)+(Δfix -pAA)

19. Comparative advantage principle: is everybody better off? • pAAA>0, pAA>0, pI≥0

20. Comparative advantage principle: is everybody better off? • pAAA>0, pAA>0, pI≥0 • Since pI =-(pAAA+ Δflt)+(Δfix -pAA)

21. Comparative advantage principle: is everybody better off? • pAAA>0, pAA>0, pI≥0 • Since pI =-(pAAA+ Δflt)+(Δfix -pAA) • Do some math…

22. Comparative advantage principle: is everybody better off? • pAAA>0, pAA>0, pI≥0 • Since pI =-(pAAA+ Δflt)+(Δfix -pAA) • Do some math… • 0<(pAAA+ pAA +pI )≤ (Δfix – Δflt)

23. Comparative advantage principle: is everybody better off? • pAAA>0, pAA>0, pI≥0 • Since pI =-(pAAA+ Δflt)+(Δfix -pAA) • Do some math… • 0<(pAAA+ pAA +pI )≤ (Δfix – Δflt) But, does it explain the growth?

24. Obstacles to accepting credit arbitrage explanation: • Credit arbitrage opportunities should be rare in reasonably efficient international credit markets. • if credit arbitrage opportunities arose, market participants would exploit and quickly eliminate them.

25. Obstacles to accepting credit arbitrage explanation: • Credit arbitrage opportunities should be rare in reasonably efficient international credit markets. • if credit arbitrage opportunities arose, market participants would exploit and quickly eliminate them. • In 1988, M.Arak, VP, Citicorp; A.Estrella, FRB of NY; L.Goodman, Goldman, Sachs & Company; A. Silver, VP, Citicorp publish an article “Interest rate swaps: an alternative explanation” in “Financial management” journal. They argue:

26. Obstacles to accepting credit arbitrage explanation: • Credit arbitrage opportunities should be rare in reasonably efficient international credit markets. • if credit arbitrage opportunities arose, market participants would exploit and quickly eliminate them. • In 1988, M.Arak, VP, Citicorp; A.Estrella, FRB of NY; L.Goodman, Goldman, Sachs & Company; A. Silver, VP, Citicorp publish an article “Interest rate swaps: an alternative explanation” in “Financial management” journal. They argue: • “… superficial interest rate savings from swaps are not necessarily motivation for swaps…” • “… tax and regulatory arbitrage do a better job of explaining the growth of the currency swap market than the growth of the interest rate swap market…”

27. IR swaps: alternative explanation • Representing borrower’s cost of a long term debt as a sum of four components:

28. IR swaps: alternative explanation • Representing borrower’s cost of a long term debt as a sum of four components: • the risk-free rate (e.g. 10-year stripped treasury note yield rate);

29. IR swaps: alternative explanation • Representing borrower’s cost of a long term debt as a sum of four components: • the risk-free rate (e.g. 10-year stripped treasury note yield rate); • the risk premium associated with the future uncertainty of this rate;

30. IR swaps: alternative explanation • Representing borrower’s cost of a long term debt as a sum of four components: • the risk-free rate (e.g. 10-year stripped treasury note yield rate); • the risk premium associated with the future uncertainty of this rate; • the credit premium attached to a specific borrower;

31. IR swaps: alternative explanation • Representing borrower’s cost of a long term debt as a sum of four components: • the risk-free rate (e.g. 10-year stripped treasury note yield rate); • the risk premium associated with the future uncertainty of this rate; • the credit premium attached to a specific borrower; • the risk premium associated with the future uncertainty of the credit premium

32. IR swaps: alternative explanation • Representing borrower’s cost of a long term debt as a sum of four components: • the risk-free rate (e.g. 10-year stripped treasury note yield rate); • the risk premium associated with the future uncertainty of this rate; • the credit premium attached to a specific borrower; • the risk premium associated with the future uncertainty of the credit premium • The authors show that:

33. IR swaps: alternative explanation • “… swaps enable borrowers to hedge fully their interest rate risk exposure, leaving the exposure to changes in their own credit premium fully unhedged.”

34. IR swaps: alternative explanation • “… swaps enable borrowers to hedge fully their interest rate risk exposure, leaving the exposure to changes in their own credit premium fully unhedged.” • “… swaps used in combination with short-term debt allow borrowers to separate risk-free rate risk and credit risk components of borrower’s cost of capital and hedge the desired amount of each.”

35. IR swaps: alternative explanation • “… swaps enable borrowers to hedge fully their interest rate risk exposure, leaving the exposure to changes in their own credit premium fully unhedged.” • “… swaps used in combination with short-term debt allow borrowers to separate risk-free rate risk and credit risk components of borrower’s cost of capital and hedge the desired amount of each.” • M.Arak et al. attribute the growth of the interest rate swap market to this ability of swaps to provide borrowers with previously unattainable interest rate risk management techniques.

36. IR swaps: alternative explanation • “… swaps enable borrowers to hedge fully their interest rate risk exposure, leaving the exposure to changes in their own credit premium fully unhedged.” • “… swaps used in combination with short-term debt allow borrowers to separate risk-free rate risk and credit risk components of borrower’s cost of capital and hedge the desired amount of each.” • M.Arak et al. attribute the growth of the interest rate swap market to this ability of swaps to provide borrowers with previously unattainable interest rate risk management techniques. • In 1992, R. Litzenberger, The Wharton School, the U of Pennsylvania, publishes an article “Swaps: plain and fanciful” in “Journal of Finance”. He supports ideas developed by M.Arak et al. and argues that an interest rate swap as form of “… synthetic fixed rate financing enhances investor’s perceptions of the firm’s future credit prospects and lowers the cost of other forms of financing…” and attributes the growth of the interest rate swap market partially to this feature of IR swaps.

37. Interpreting an IR swap position • A fixed-for-floating IR swap position can be interpreted as a series of FRA’s: fixed rate payer has a long FRA, floating rate payer has a short FRA;

38. Interpreting an IR swap position • A fixed-for-floating IR swap position can be interpreted as a series of FRA’s: fixed rate payer has a long FRA, floating rate payer has a short FRA; • Nevertheless, the following makes IR swaps valuable financial instrument:

39. Interpreting an IR swap position • A fixed-for-floating IR swap position can be interpreted as a series of FRA’s: fixed rate payer has a long FRA, floating rate payer has a short FRA; • Nevertheless, the following makes IR swaps valuable financial instrument: • transaction efficiency: in one deal two parties achieve a payoff equivalent to a package of FRA’s each of which would have to be negotiated separately;

40. Interpreting an IR swap position • A fixed-for-floating IR swap position can be interpreted as a series of FRA’s: fixed rate payer has a long FRA, floating rate payer has a short FRA; • Nevertheless, the following makes IR swaps valuable financial instrument: • transaction efficiency: in one deal two parties achieve a payoff equivalent to a package of FRA’s each of which would have to be negotiated separately; • maturity span: maturities of FRA’s don’t extend out as far as those of interest rate swaps;

41. Interpreting an IR swap position • A fixed-for-floating IR swap position can be interpreted as a series of FRA’s: fixed rate payer has a long FRA, floating rate payer has a short FRA; • Nevertheless, the following makes IR swaps valuable financial instrument: • transaction efficiency: in one deal two parties achieve a payoff equivalent to a package of FRA’s each of which would have to be negotiated separately; • maturity span: maturities of FRA’s don’t extend out as far as those of interest rate swaps; • market liquidity;

42. How IR swaps market started: summary IR swaps originally developed around the purpose of exploiting credit arbitrage opportunities but eventually evolved into transactionally efficient instrument for managing interest rate risk exposure and accomplishing asset/liability objectives.

43. Evolution of swaps market: intermediary • The evolution of swaps market was mostly determined by the role of an intermediary played in a swap deal. • In the early stages of the market swap deal were characterized by three important features: 1. barter: two counterparties with exactly offsetting exposures were introduced by a third party, usually a bank; 2. arbitrage: the swap was driven by a credit or market-access arbitrage which gave some profit to all three parties; 3. liability driven: almost all swaps were driven by the need to manage a debt issue on both sides. • In essence, the intermediary, a commercial or investment bank, only performed the function of a broker.

44. Evolution of swaps market: intermediary • The evolution of swaps market was mostly determined by the role of an intermediary played in a swap deal. • In the early stages of the market swap deal were characterized by three important features: 1. barter: two counterparties with exactly offsetting exposures were introduced by a third party, usually a bank; 2. arbitrage: the swap was driven by a credit or market-access arbitrage which gave some profit to all three parties; 3. liability driven: almost all swaps were driven by the need to manage a debt issue on both sides. • In essence, the intermediary, a commercial or investment bank, only performed the function of a broker. • Sometimes in order to balance out a deal the bank became the counterparty to a swap to the extent of the difference between notional amounts and hedged this position using, for example, a series of FRAs.

45. Evolution of swaps market: intermediary • In other cases, if a swap involved a higher and a lower credit-grade entity, the lower credit-grade entity was required to obtain a guarantee from a highly rated bank to reduce the risk of default. Participation as a guarantor was another reason leading banks to accepting role of counterparty. • As swap deals became more frequent and hedging techniques advanced, banks started participating more as the counterparty to a swap.

46. Evolution of swaps market: intermediary • In other cases, if a swap involved a higher and a lower credit-grade entity, the lower credit-grade entity was required to obtain a guarantee from a highly rated bank to reduce the risk of default. Participation as a guarantor was another reason leading banks to accepting role of counterparty. • As swap deals became more frequent and hedging techniques advanced, banks started participating more as the counterparty to a swap. • Eventually, when a bank had one entity willing to enter a swap, the bank became the counterparty. Consequently, interest rate swaps were added to the inventory of bank's financial products and banks started quoting bid-ask spreads on swaps.

47. Evolution of swaps market: intermediary • As more and more banks entered the swaps market the competition narrowed bid-ask spreads. To profit from swap deals banks had to do a large volume of business which required a broad base of clients willing to use swaps, and a large inventory of swaps. • Consequently, the role of a bank in swap transactions transformed from a broker to a dealer.

48. Evolution of swaps market: intermediary • As more and more banks entered the swaps market the competition narrowed bid-ask spreads. To profit from swap deals banks had to do a large volume of business which required a broad base of clients willing to use swaps, and a large inventory of swaps. • Consequently, the role of a bank in swap transactions transformed from a broker to a dealer. • Layard-Liesching points out in an article “Swap fever” published in “Euromoney” magazine in 1986: “… this plunge in spreads was fantastic for final users: the barter search was eliminated and, with liquidity available, swaps could now be used for active asset and liability management.“

49. Evolution of swaps market: intermediary • As more and more banks entered the swaps market the competition narrowed bid-ask spreads. To profit from swap deals banks had to do a large volume of business which required a broad base of clients willing to use swaps, and a large inventory of swaps. • Consequently, the role of a bank in swap transactions transformed from a broker to a dealer. • Layard-Liesching points out in an article “Swap fever” published in “Euromoney” magazine in 1986: “… this plunge in spreads was fantastic for final users: the barter search was eliminated and, with liquidity available, swaps could now be used for active asset and liability management.“ • Nevertheless, a significant percentage of swap deals is still arranged by brokers:http://www.isda.org

50. Evolution of swaps market: documentation • Swaps are typically initiated through phone conversations. The initial agreement stipulates a few economic issues such as the fixed rate, the floating rate, the payment frequency, the notional amount and the maturity of the swap. This verbal agreement is confirmed by a fax or e-mail usually within 24 hours. • Although both parties are legally bound by the initial agreement, the contract is far from complete. Extensive documentation which must cover all terms agreed to initially and must also cover many incidental issues such as events of default, methods of computing damages on early termination, jurisdiction governing disputes etc. is exchanged later.