Using Swaptions in an LDI Framework

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Using Swaptions in an LDI Framework

  1. 1. Teach-In Using Swaptions in an LDI Framework 05 December 2012Dan Mikulskis (Redington)Alex Soulsby (F&C)1
  2. 2. Teach-In Using Swaptions in an LDI Framework 05 December 2012The Seven Steps to Full Funding TM
  3. 3. Teach-In Using Swaptions in an LDI Framework 05 December 2012The Fosbury Flop3Friends Provident 2003Mexico 1968
  4. 4. Teach-In Using Swaptions in an LDI Framework 05 December 2012SwaptionsObjectives of today’s Teach-in4- To gain a clear sense of why a pension scheme might want to use swaptions.- To gain a sufficient level of knowledge about the language of swaptions to confidently engage in discussions.- To have seen examples of specific transactions that have been successfully implemented by pension funds.- To understand how pension schemes can set themselves up to efficiently implement a swaptions strategy.
  5. 5. Teach-In Using Swaptions in an LDI Framework 05 December 2012SwaptionsThe Key Benefits- Swaptions can be used as an alternative to swaps for hedging some of the interest rate risk of a pension schemeUnder most scenarios you can see better outcomes- Swaptions can also be used as an alternative to trigger levels, in order to lock into higher yields if yields were to riseThe Scheme therefore collects a premium for agreeing to enter into a swap if yields rise to a certain level5
  6. 6. Teach-In Using Swaptions in an LDI Framework 05 December 2012SwaptionsIn detailA Swaption is an option to enter into a swapThere are two flavours of Swaption :Payers – an option to enter into a swap paying the fixed legReceivers – an option to enter into a swap receiving the fixed legIn each case there are certain other parameters which apply :The expiry of the option, this defines at which future point we are able to exercise the optionThe term of the swap we are talking about, this need not be the same as the expiry of the option and most of the time will notbe. This can be anything from 1-30 years. For a pension scheme this might typically be 20 or 30 yearsThe Strike. This is the fixed rate of the swap which we have the option to enter intoThe Notional. This is the notional or principal value of the swap contract underlying the SwaptionOther notesIn all cases we are talking about par swaps, as opposed to the zero-coupon swaps we would normally advise clients use forhedging6
  7. 7. Teach-In Using Swaptions in an LDI Framework 05 December 2012SwaptionsIn detailExample (1)A pension scheme might buy £100m notional 7y30y receiver Swaption with strike of 2.5%, for a premium of £3.5m This means:The scheme will pay £3.5m, plus transaction costs (on day 1, the Swaption will be an asset worth £3.5m)In 7 years from nowThe scheme has the right (but not the obligation)To enter into a 30 year swap on a notional of £100mReceiving a fixed rate of 2.5%Clearly in practice it would be profitable to exercise this only if 30yr rates were below 2.5% at the point of expiry in 7 years71 2 3 4 5 6 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 367 370Time zero: schemebuys7y30y receiverSwaption, pays premiumAt seven years, scheme has the option toenter into a fixed rate swap, receiving afixed rate of 2.5%p.a. over the next 30years (and paying LIBOR floating)If the option was exercised thescheme then receives fixed andpays LIBOR floating for the life ofthe swap
  8. 8. Teach-In Using Swaptions in an LDI Framework 05 December 20121 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21SwaptionsIn detailExample (2)A pension scheme might sell £75m notional 2y20y payer Swaption with strike of 4% for a premium of £1.4m This means:The scheme receives premium of £1.4m, less transaction costs (on day 1, the Swaption sits as a liability of £1.4m)In 2 years from nowThe trading counterparty the scheme has sold the option to has the right (but not the obligation)To enter into a 20 year swap with a notional of £75m with the schemePaying a fixed rate of 4% (i.e. the scheme would receive the fixed rate of 4%)Clearly in practice it would be profitable to exercise this only if 20yr rates were above 4% at the point of expiry in 2 yearsNote the difference to the previous example, here the trading counterparty rather than the scheme has the optionality.That is because we have sold rather than bought an optionIn turn we should receive, rather than pay, a premium for this82 220At two years, thecounterparty thescheme has tradedwith has the option toenter into a swappaying a fixed rate of4%Time zero: scheme sells 2y20y payerswaption – receives premiumIf the option was exercised thescheme then receives fixed and paysLIBOR floating for the life of the swap
  9. 9. Teach-In Using Swaptions in an LDI Framework 05 December 2012SwaptionsDetail deltaA position in any option contract, swaptions included, introduces sensitivities to a number of factors, these are known as theGreeks. G s rThe most important among these is delta – the sensitivity of the price of the option to a small move in the underlyingA fixed interest rate swap has a delta, more commonly known as the PV01If rates are shifted by 1 basis point, the PV01 tells us by how much the value of our swap position changesSwaptions also have a PV01 – and this is why they are useful for scheme hedging purposes9
  10. 10. Teach-In Using Swaptions in an LDI Framework 05 December 20120%10%20%30%40%50%60%70%80%90%100%SwaptionDeltaas%ofSwapDeltaUnderlying 30 year rateSwaptionsReceiver Swaption on the 30 year swap rate struck at 2.5%Intuitive understanding of Swaption deltaFor a swap, the PV01 will be relatively constant for small moves in ratesFor a Swaption, the PV01 will change as rates changeAn intuitive way of thinking of the Swaption PV01 is to relate it to the PV01 of the underlying swap, and think about the probability of exerciseLet us go back to the previous example of a £100m receiver Swaption on the 30 year swap rate struck at 2.5%Lets say the Swaption is close to expiry now, the PV01 of the 30 year par swap is about £200kThe delta of the Swaption will vary with the underlying rate as follows10
  11. 11. Teach-In Using Swaptions in an LDI Framework 05 December 2012SwaptionsDetail deltaThe delta of the Swaption will vary with the underlying rateIn-The-Money Swaption110%10%20%30%40%50%60%70%80%90%100%SwaptionDeltaas%ofSwapDeltaUnderlying 30 year rateThe Swaption is very likely to be exercised –and become a swapTherefore the delta “behaves like a swap”
  12. 12. Teach-In Using Swaptions in an LDI Framework 05 December 2012SwaptionsDetail deltaOut-Of-The-Money Swaption120%10%20%30%40%50%60%70%80%90%100%SwaptionDeltaas%ofSwapDeltaUnderlying 30 year rateThe Swaption is very unlikely to be exercised– and become a swapTherefore the delta is close to zero
  13. 13. Teach-In Using Swaptions in an LDI Framework 05 December 2012SwaptionsDetail deltaAt-The-Money Swaption130%10%20%30%40%50%60%70%80%90%100%SwaptionDeltaas%ofSwapDeltaUnderlying 30 year rateThe probabilities are balanced as to whetherthe Swaption will become a swap or notTherefore the delta is close to 50%
  14. 14. Teach-In Using Swaptions in an LDI Framework 05 December 20124.0% 1.0%1.5%1.7%16.9%5.1%1.5%1.0%13.6%19.0%0.0%5.0%10.0%15.0%20.0%25.0%30.0%35.0%40.0%%oftotalliabilities4.0% 1.0%1.5%1.7%20.0%5.1%1.5%12.7%22.0%0.0%5.0%10.0%15.0%20.0%25.0%30.0%35.0%40.0%%oftotalliabilitiesSwaptionsEvaluating swaptions in an overall risk frameworkThe overall risk reducing properties of swaptions for a pension scheme can be evaluated in the usual wayBelow examples are illustrative – actual impact will depend completely on the size of the Swaption transactionSwaption will1. Reduce interest rate risk2. Introduce small risk to the market price of the Swaption itself (vega risk), which is found to be diversified away – as long as Swaptionposition is appropriately sizedThe illustration below is for a scheme with the following properties :• Inflation hedge ratio exceeds interest rate hedge ratio• Interest rates represent largest single risk factor14Starting point – no SwaptionWith Swaption
  15. 15. Teach-In Using Swaptions in an LDI Framework 05 December 2012SwaptionsExecuting Swaptions Requires Efficient Governance15• Proactive involvement of Investment Manager• Timely, focused meeting of InvestmentCommittee• Constructive discussion from InvestmentConsultantInvestmentCommittee /Working GroupInvestmentConsultantTrustee Board• Set strategic objectives• Establish risk budget• Delegate some decisionmaking abilityLDI ManagerControl Agility & FocusTransparency
  16. 16. Teach-In Using Swaptions in an LDI Framework 05 December 201213-15 Mallow Street London EC1Y 8RD Telephone : +44 (0) 20 7250 3331 www.redington.co.ukContactsDan MikulskisDirectorALM & Investment StrategyDirect Line: 020 7250 7107dan.mikulskis@redington.co.uk16DisclaimerFor professional investors only. Not suitable for privatecustomers.The information herein was obtained from varioussources. We do not guarantee every aspect of itsaccuracy. The information is for your private informationand is for discussion purposes only. A variety of marketfactors and assumptions may affect this analysis, and thisanalysis does not reflect all possible loss scenarios. Thereis no certainty that the parameters and assumptions usedin this analysis can be duplicated with actual trades. Anyhistorical exchange rates, interest rates or other referencerates or prices which appear above are not necessarilyindicative of future exchange rates, interest rates, or otherreference rates or prices. Neither the information,recommendations or opinions expressed hereinconstitutes an offer to buy or sell any securities, futures,options, or investment products on your behalf. Unlessotherwise stated, any pricing information in this messageis indicative only, is subject to change and is not an offerto transact. Where relevant, the price quoted is exclusiveof tax and delivery costs. Any reference to the terms ofexecuted transactions should be treated as preliminaryand subject to further due diligence .Please note, the accurate calculation of the liability profileused as the basis for implementing any capital marketstransactions is the sole responsibility of the Trusteesactuarial advisors. Redington Ltd will estimate theliabilities if required but will not be held responsible forany loss or damage howsoever sustained as a result ofinaccuracies in that estimation. Additionally, the clientrecognizes that Redington Ltd does not owe any party aduty of care in this respect.Redington Ltd are investment consultants regulated bythe Financial Services Authority. We do not advise on allimplications of the transactions described herein. Thisinformation is for discussion purposes and prior toundertaking any trade, you should also discuss with yourprofessional tax, accounting and / or other relevantadvisers how such particular trade(s) affect you. Allanalysis (whether in respect of tax, accounting, law or ofany other nature), should be treated as illustrative onlyand not relied upon as accurate.©Redington Limited 2011. All rights reserved. Noreproduction, copy, transmission or translation in wholeor in part of this presentation may be made withoutpermission. Application for permission should be made toRedington Limited at the address below.Redington Limited (6660006) is registered in England andWales. Registered office: 13-15 Mallow Street LondonEC1Y 8RD

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