1. www.fandc.com
Interest rate hedging with swaptions
December 2012

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 hedge
2
Hedging dilemma
Levels of yields
Don’t hedge
Affordability issue
Swaptions allows scheme to capture specific scenarios
Dilemma
Mismatch to liabilities
Hedge
Deflation risk

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 rates
3
Sell upside beyond triggers to fund downside protection

4. Hedging strategy for rates rising
 Sell one or more payer swaptions with strike set to
coincide with scheme’s triggers
 If rates rise beyond strike, scheme will be forced to
hedge at this level…a trade it would have
done anyway
 Swaptions monetise this commitment, hence
compare favourably to triggers in almost
all scenarios
4
Nominal
interest rates
Scheme’s solvency
position
Sell upside beyond triggers Payer swaption
premium boosts
scheme returns
Payer expires
worthless,
premium collected
Payer caps rates
upside to solvency
Solvency position
without payer

5. Hedging strategy for rates falling
 Selling payers monetises some of the upside benefit
from rate rises, however offers no downside
protection if rates fall
 A scheme can buy protection against such falls in
nominal interest rates by buying receiver swaptions
 The premium generated from payer sale could be
used to purchase receiver swaptions
5
Protect against fall in rates
Nominal
interest rates
Scheme’s solvency
position
Sell upside to
fund downside
Benefit from receiver
caps fall in solvency
Solvency position
without swaptions
Payer caps rates
upside to solvency

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)
6
Payoff at expiry
Equidistant from ATMF of 3.14%
Sell payer at 3.64%
Buy receiver at 2.64%
Value
Interest rates
Trade structured to be premium neutral
Collar
Liabilities

7. Drivers of the swaption price
 The value of a swaption can be separated
into two positive numbers: intrinsic value
+ time value
 The intrinsic value is the value the option
would have if market conditions were left
unchanged up to expiry date
 The time value is simply the difference
between the price of the swaption and its
intrinsic value, effectively capturing the
option value embedded in the
time-to-maturity
7
Factor Time value Intrinsic value
Rate -
Time decay -
Volatility -
Example: 4% Receiver swaption
Time value
Intrinsic
value
Interest Rates
3.0% 4.0% 5.0%
Swaption
Out-of-the-Money
Swaption
In-the-Money

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 expiry
8
2 Year time horizon
Time (years)
0 1 2 3 4 5
2 year option decays faster
5 year option 2 year option

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 option
9
Sell
here
Buy
here
50
55
60
65
70
75
80
85
1M 3M 6M 1Y 2Y 3Y 4Y 5Y 7Y 10Y
Buy cheap option, sell expensive option

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)
10
Buy cheap option, sell expensive option
Net premium is £9.6 million…
…but trade structured to be time decay neutral after 2 years

11. Spot (i.e upfront) premium swaptions
 Spot premium received at inception
 Counterparty requires collateral for
value of swaption
 Premium returned as collateral
11
Payout on swaption at
expiry
Spot premium
received upfront
Value(%ofnotional)
-2.00
2.00
4.00
-4.00
0.00
Time
Swaption value = collateral (excludes premium)

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 up
12
Payout on swaption
at expiry
Forward premium
received at expiry
Value(%ofnotional)
-2.00
2.00
4.00
-4.00
0.00
Time
Swaption value = collateral (includes premium)

13. Strategy comparison after 2 years
13
Change in value after 2 years
(30)
(20)
(10)
-
10
20
30
40
-100 -50 0 50 100
Rates shift (bps)
Changeinvalue(£m)
Split expiry collar Zero cost collar Hedged liability
Split collar outperforms both
liabilities and ZC collar
Split collar retains its value
after 2 years

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 approach
14

15. 15
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