www.fandc.comInterest rate hedging with swaptionsDecember 2012
Swaptions in LDI framework Trustees concerned about un-hedged inflation and interest rate risk Trustees could hedge infl...
Trustee decision framework Replace triggers with swaptions to lock in to higher rates Add downside protection with swapt...
Hedging strategy for rates rising Sell one or more payer swaptions with strike set tocoincide with scheme’s triggers If ...
Hedging strategy for rates falling Selling payers monetises some of the upside benefitfrom rate rises, however offers no ...
Zero premium collar Buy £100m of 2y30y receiver at 2.64% for £3.9m (3.9% premium) Sell £100m 2y30y payer at 3.64% for £3...
Drivers of the swaption price The value of a swaption can be separatedinto two positive numbers: intrinsic value+ time va...
Split expiry collar – time decay As time passes, all else being equal swaption value (time value) declines Time decay is...
Split expiry collar - volatility Sell 2 year payer swaption Higher 2-year volatility =dearer option Buy 5 year receiver...
Split expiry collar Buy £200m 5y30y receiver at 2.98% for £13.5m (6.8% premium)(Previously £100m of 2y30y receiver at 2.6...
Spot (i.e upfront) premium swaptions Spot premium received at inception Counterparty requires collateral forvalue of swa...
Forward premium swaptions Forward premium received at expiry Net value at inception is 0 No collateral required at star...
Strategy comparison after 2 years13Change in value after 2 years(30)(20)(10)-10203040-100 -50 0 50 100Rates shift (bps)Cha...
Implementation and considerations Select proportion and size of swaptions hedge Determine impact on scheme’s hedge Exam...
15This document is being distributed only to and directed only at (i) persons who have professional experience in matters ...
ContactUnited KingdomF&C Management LimitedExchange HousePrimrose StreetLondon EC2A 2NYTel: +44 (0) 20 7628 8000Fax: +44 (...
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Interest Rate Hedging with Swaptions

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Interest Rate Hedging with Swaptions

  1. 1. www.fandc.comInterest rate hedging with swaptionsDecember 2012
  2. 2. Swaptions in LDI framework Trustees concerned about un-hedged inflation and interest rate risk Trustees could hedge inflation now, low by historical standards Levels of nominal yields have remained low, less compelling to hedge2Hedging dilemmaLevels of yieldsDon’t hedgeAffordability issueSwaptions allows scheme to capture specific scenariosDilemmaMismatch to liabilitiesHedgeDeflation risk
  3. 3. Trustee decision framework Replace triggers with swaptions to lock in to higher rates Add downside protection with swaptions to protect against pain of lower rates3Sell upside beyond triggers to fund downside protection
  4. 4. Hedging strategy for rates rising Sell one or more payer swaptions with strike set tocoincide with scheme’s triggers If rates rise beyond strike, scheme will be forced tohedge at this level…a trade it would havedone anyway Swaptions monetise this commitment, hencecompare favourably to triggers in almostall scenarios4Nominalinterest ratesScheme’s solvencypositionSell upside beyond triggers Payer swaptionpremium boostsscheme returnsPayer expiresworthless,premium collectedPayer caps ratesupside to solvencySolvency positionwithout payer
  5. 5. Hedging strategy for rates falling Selling payers monetises some of the upside benefitfrom rate rises, however offers no downsideprotection if rates fall A scheme can buy protection against such falls innominal interest rates by buying receiver swaptions The premium generated from payer sale could beused to purchase receiver swaptions5Protect against fall in ratesNominalinterest ratesScheme’s solvencypositionSell upside tofund downsideBenefit from receivercaps fall in solvencySolvency positionwithout swaptionsPayer caps ratesupside to solvency
  6. 6. Zero premium collar Buy £100m of 2y30y receiver at 2.64% for £3.9m (3.9% premium) Sell £100m 2y30y payer at 3.64% for £3.9m (3.9% premium)6Payoff at expiryEquidistant from ATMF of 3.14%Sell payer at 3.64%Buy receiver at 2.64%ValueInterest ratesTrade structured to be premium neutralCollarLiabilities
  7. 7. Drivers of the swaption price The value of a swaption can be separatedinto two positive numbers: intrinsic value+ time value The intrinsic value is the value the optionwould have if market conditions were leftunchanged up to expiry date The time value is simply the differencebetween the price of the swaption and itsintrinsic value, effectively capturing theoption value embedded in thetime-to-maturity7Factor Time value Intrinsic valueRate -Time decay -Volatility -Example: 4% Receiver swaptionTime valueIntrinsicvalueInterest Rates3.0% 4.0% 5.0%SwaptionOut-of-the-MoneySwaptionIn-the-Money
  8. 8. Split expiry collar – time decay As time passes, all else being equal swaption value (time value) declines Time decay is slower initially but accelerates closer to expiry82 Year time horizonTime (years)0 1 2 3 4 52 year option decays faster5 year option 2 year option
  9. 9. Split expiry collar - volatility Sell 2 year payer swaption Higher 2-year volatility =dearer option Buy 5 year receiver swaption Lower 5-year volatility =cheaper option9SellhereBuyhere50556065707580851M 3M 6M 1Y 2Y 3Y 4Y 5Y 7Y 10YBuy cheap option, sell expensive option
  10. 10. Split expiry collar Buy £200m 5y30y receiver at 2.98% for £13.5m (6.8% premium)(Previously £100m of 2y30y receiver at 2.64%) Sell £100m 2y30y payer at 3.64% for £3.9m (3.9% premium)10Buy cheap option, sell expensive optionNet premium is £9.6 million……but trade structured to be time decay neutral after 2 years
  11. 11. Spot (i.e upfront) premium swaptions Spot premium received at inception Counterparty requires collateral forvalue of swaption Premium returned as collateral11Payout on swaption atexpirySpot premiumreceived upfrontValue(%ofnotional)-2.002.004.00-4.000.00TimeSwaption value = collateral (excludes premium)
  12. 12. Forward premium swaptions Forward premium received at expiry Net value at inception is 0 No collateral required at start Now market standard between banks Avoids collateral being locked up12Payout on swaptionat expiryForward premiumreceived at expiryValue(%ofnotional)-2.002.004.00-4.000.00TimeSwaption value = collateral (includes premium)
  13. 13. Strategy comparison after 2 years13Change in value after 2 years(30)(20)(10)-10203040-100 -50 0 50 100Rates shift (bps)Changeinvalue(£m)Split expiry collar Zero cost collar Hedged liabilitySplit collar outperforms bothliabilities and ZC collarSplit collar retains its valueafter 2 years
  14. 14. Implementation and considerations Select proportion and size of swaptions hedge Determine impact on scheme’s hedge Examine how the swaptions could perform under different scenarios Determine appropriate collateral requirements Timing and execution approach14
  15. 15. 15This document is being distributed only to and directed only at (i) persons who have professional experience in matters relating to investments falling within Article19(5) of the Financial Services and Markets Act 2000 (Financial Promotion) Order 2001, as amended (the “Order”), and (ii) persons falling within Article 49(2)(a) to (d)of the Order and other persons to whom it may otherwise lawfully be communicated (all such persons together being referred to as “relevant persons”). Thisdocument must not be acted on or relied on by persons who are not relevant persons.This document does not constitute, or form part of, any solicitation of any offer to deal in any investment. This document, and the trading ideas and preliminaryinvestment advice contained in it, is provided only to assist financially sophisticated investors in arriving at an independent investment decision and is not intended tobe, and must not alone be taken as, the basis for an investment decision. This document, and the trading ideas and preliminary investment advice contained in it,may not be solely relied on in connection with an investment decision and each recipient of this document should make such investigations as it deems necessary toarrive at an independent evaluation of any transaction described in this document, and should consult its own legal counsel and financial, actuarial, accounting,regulatory and tax advisers to evaluate whether to make such an investment.All information herein is indicative based on certain assumptions and current market conditions and is subject to change without notice. Information other thanindicative terms (including market data and statistical information) has been obtained from various sources. No representation or warranty, express or implied, isgiven and no responsibility or liability is or will be accepted by or on behalf of F&C or by any of its subsidiaries, affiliates, employees, directors, officers or agents orany other person as to the accuracy, completeness or correctness of the information contained in this document or any other oral information made available and anysuch liability (whether in negligence or otherwise) is expressly disclaimed. Any analysis presented herein that indicates a range of outcomes that may result fromchanges in market parameters is not comprehensive, is not intended to suggest that outcome is more likely than another and may have been derived using F&Cproprietary models, historic data and subjective interpretation. Opinions expressed are our current opinions as of the date appearing on this material only.Certain transactions, including those involving futures, options and high yield securities, give rise to substantial risk and are not suitable for all investors. Foreigncurrency denominated securities are subject to fluctuations in exchange rates that could have an adverse effect on the value or price of, or income derived from, theinvestment. Where investments are made in emerging markets, unquoted securities or smaller companies, their potential volatility may increase the risk to the valueof, and the income from, the investment. Transactions of the sort described herein contain complex characteristics and risk factors. Past performance should not beseen as an indication of future performance. The value of investments and the income derived from them can go down as well as up as a result of market or currencymovements and investors may not get back the original amount invested. Transactions incorporating derivatives may create additional risks and exposures.F&C, or any connected or associated person, may hold a long or short position or a derivative interest in the financial instruments of any issuer referred to herein ormay otherwise have a material interest in the transactions described herein.Important information
  16. 16. ContactUnited KingdomF&C Management LimitedExchange HousePrimrose StreetLondon EC2A 2NYTel: +44 (0) 20 7628 8000Fax: +44 (0) 20 7770 5487Website: www.fandc.comAuthorised and regulated in the UKby the Financial Services Authority.United KingdomF&C Management Limited80 George StreetEdinburgh EH2 3BUScotlandTel: +44 (0) 20 7628 8000Authorised and regulated in the UK by theFinancial Services Authority.United KingdomF&C REIT Property AssetManagement Plc5 Wigmore StreetLondonW1U 1PBTel: +44 (0) 20 7499 2244F&C REIT Property Asset Management Plcis a wholly owned subsidiary of F&C REITAsset Management LLP and is authorisedand regulated by the Financial ServicesAuthority.United KingdomThames River Capital LLPExchange HousePrimrose StreetLondon EC2A 2NYTel: +44 (0) 20 7628 8000Fax: +44 (0) 20 7770 5487The Funds business of the F&C Group.Authorised and regulated in the UK by theFinancial Services Authority.NetherlandsF&C Netherlands B.V.Jachthavenweg 109 e1081 KM AmsterdamNetherlandsTel: +31 (0) 20 582 3000Regulated in the Netherlands by theAutoriteit-FM.PortugalF&C Portugal, Gestão dePatrimónios, S.A.Rua de Campolide,3721st floor1070-040 LisboaPortugalTel: +351 (0) 21 003 3200Regulated in Portugal by the CMVM and theBank of Portugal.GermanyF&C Management LimitedOeder Weg 11360318 FrankfurtGermanyTel: +49 (0) 69 597 99 080Authorised and regulated in the UKby the Financial Services Authority.IrelandF&C Ireland LimitedBlock 5Harcourt CentreHarcourt RoadDublin 2Tel: +353 (0) 1 436 4000F&C Ireland is regulated by the CentralBank of Ireland.SwitzerlandF&C Management LtdRigistrasse 36300 ZugSchwitzerlandTel: +41 (0) 41 711 6262Authorised and regulated in the UK by theFinancial Services Authority.United StatesF&C Management Limited265 Franklin Street16th FloorBoston MA 02110USATel: +1 (0) 617 426 9050Authorised and regulated in the UKby the Financial Services Authority.Hong KongF&C Management Limited66th Floor, Suite 01The Center99 Queen’s Road CentralHong KongTel: +852 3965 3160Authorised and regulated in the UKby the Financial Services Authority.IndiaIndiareit Fund AdvisorsPvt. LimitedPiramal Tower, Ground FloorPeninsula Corporate ParkG.K. Marg, Lower ParelMumbai 400 013IndiaTel: +91 (0) 22 61513440Indiareit Fund Adivsors Pvt. Limited is astrategic partner to F&C REIT PropertyAsset Management LLP. Part of the F&CAsset Management Plc Group.GermanyF&C REIT Property AssetManagementGmbH & Co. KGOberanger 34-3680331 MünchenGermanyTel: +49 (0) 89 61 46 51 0F&C REIT Property Asset Management Plcis a wholly owned subsidiary of F&C REITAsset Management LLP and is authorisedand regulated by the Financial ServicesAuthority.Past performance should not be seen as an indication of future performance. The value of investments and income derived from them can go down as well as up as a result of market or currency movements and investors may not get back theoriginal amount invested. The information, opinions estimates or forecasts contained in this document were obtained from sources reasonably believed to be reliable and are subject to change at any time. F&C Group Companies may from timeto time deal in investments mentioned herein on behalf of their clients. The source of information in all graphs is F&C unless otherwise stated. F&C Management Limited is authorised and regulated by the Financial Services Authority (FSA)FRN:119230. Limited by shares. Registered in England and Wales, No. 517895. Registered address and Head Office: Exchange House, Primrose Street, London, EC2A 2NY, United Kingdom. F&C Asset Management plc is the listed holdingcompany of the F&C group. F&C Management Limited is a member of the F&C Group of companies and a subsidiary of F&C Asset Management plc. F&C, the F&C logo, REO and the ‘reo’ logo are registered trade marks of F&C AssetManagement plc. F&C INVESTMENTS and the F&C INVESTMENTS logo are trade marks of F&C Management Limited. © Copyright F&C Management Limited 2012. All Rights Reserved. Neither this document nor any part of it may bereproduced by any party whether by photocopying or storing in any medium by electronic means or otherwise without the prior approval of F&C Management Limited.CN: 01072

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