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Libor OIS trading
The document provides a comprehensive guide to overnight index swaps (OIS) and their trading mechanisms, detailing their structure and relationships to other interest rate derivatives like forward rate agreements (FRAs). It explains the significance of the London Interbank Offered Rate (LIBOR) as a reference rate, the nature of OIS as notional contracts minimizing counterparty risk, and their settlement processes. Additionally, it discusses the correlation between FRA/OIS spreads and the credit quality of financial institutions.
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Libor OIS trading
- 1. Overnight Index Swaps A guide to OIS trading Josie von Etzdorf and Francois Choquet Advanced Specialists Asia Pac Analytics 2011
- 2. Growth of ShortTerm IR Trading Single Currency Interest Rate Swaps and Forwards < 1 y Maturity (in mln) Asia Pac Analytics 2011
- 3. Libor • Libor standsfor London Interbank Offered Rate, a daily fixing set at 11.00 a.m. London time by the British Bankers’ Association as a set of reference rates for USD, EUR, GBP, JPY, CAD, AUD, NZD, CHF, DKK, SEK. • Contributor banks post a rate at which they could borrow unsecured money in reasonable market size in the interbank market. • The rates are averaged after removing the top and bottom quartile. • {BBAM1<Go>} displays the fixings which are
- 4. BBA USD LiborFixings
- 5. US0003M<INDEX> • The USD3 month LIBOR fixing is the most used short term reference rate around the world. • EDA<CMDTY>, the globally most active interest rate future uses 3 month LIBOR as the underlying notional. • Floating rate bonds use Libor + (or -) a spread as their coupon. {EF1653262<CORP>DES<GO>} • Interest Rate Swaps use 3 month LIBOR as the floating reference rate. {USSW5<CRNCY>DES<GO>} • Corporate loans are typically set with LIBOR plus a spread. {LN302060<CORP>YA<GO>}
- 10. Forward Rate Agreements- FRAs • A derivative which uses a combination of interbank rates and futures to price notional interbank borrowing or lending. • {EDSF<GO>} • These are actively traded {TPFR<GO>} • {SL3L1HI6<CORP>SWPM<GO>} • The Libor rate 2 days prior to the effective date is the reference used to settle the contract using money market conventions.
- 14. IMM Dates • FRAsand short term Swaps often trade using IMM (International Monetary Market sector of the Chicago Mercantile Exchange) dates to match Futures expiry. • Eurodollar futures expire on the third Wednesday of the contract month, thus the last trade is 2 days prior e.g. EDU1<CMDTY> ends on September 21st, thus September 19th. EDZ1 expires on December 21st, with a last trade on December 19th. {EDA<CMDTY>EXS<GO>} • The September contract is a notional interbank 3 month deposit with dates matching the futures, thus September 21st to December 21st .
- 16. OIS- Overnight-Indexed Swaps •An Overnight-Indexed Swap (OIS) is like a plain vanilla fixed/floating interest rate swap but the floating leg is a reference published overnight rate, which compounds daily. • It is usually a short term swap and unlike an interbank deposit, the fact that this is a notional contract means that counterparty risk is minimised. • For trades with a maturity up to One Year, at maturity the difference between interest accrued at the fixed rate and interest accrued at the compounded floating rate on the agreed notional amount of the swap is settled as a one time payment. • In the case of longer term swaps, there will be a Monthly, Quarterly, Semi annual or Annual coupon payment dates subject to local market convention. • {TPOS<GO>}
- 18. FRA/OIS spread • Directmeasure of the credit quality of financial institutions. • A long FRA/OIS spread represents a view on or hedge for deteriorating bank credit quality, thus gives exposure to the spread which increases with worsening bank credit quality. • Strong correlation between CDS and FRA/OIS spread. Asia Pac Analytics 2011
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- 20. HEDGING WITH FRA-OIS 3 Months 3 Months FRA FRA FRA Trade valuation fixing settlement Maturity 2 bus days 2 bus OIS 2 bus OIS days OIS Maturity days Settle Starts Fixed Rate for Forward Fixed Rate FRA Starting OIS Swap Dealer Investor FRA Counterparty 3 month OIS 3 month Libor Expected Payoff at Maturity: 3mL – 3m OIS – Libor/OIS Spread Asia Pac Analytics 2011
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- 22. FRA/OIS TRADE EUR 800mmFRA/OIS 9X12 on the 20th; Trade date: 3/18/2010 OIS 0.92% FRA 1.17 % Swap Dealer Investor FRA Counterparty 3 month OIS 3 month Euribor Expected Payoff : 3mL – 3m OIS – 25 bps At settlement 12/22/2010 = EURIBOR 3M / OIS 3M ≈ 45 bps Trade P&L at unwind ≈ 20 bps Asia Pac Analytics 2011
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Editor's Notes
- #3 The demand for short term interest rate instruments and derivatives have increased on average by 20% every year for the last 10 years. This rapid increase is due to a combination of factors including the extreme volatility of money market rates, the dislocations in the interbank market and the actions from central banks to provide liquidity. Because Interest rate derivatives such as the FRA or OIS are customized contracts they became the vehicle of choice among participants to express a view or hedge against benchmark rates. In this tutorial, we are going to look at a popular trade: (1) The FRA/OIS spread. We will start by reviewing the building blocks of the Libor and overnight lending market and then describe the transaction in detail through its life cycle: the initial set up, the monitoring of profit and losses and unwinding through the Swap Manager Function SWPM.
- #19 The spread between current 3-month LIBOR and spot 3-month OIS (often called the LIBOR/OIS spread) is now frequently cited by the financial press, market commentators and policymakers. The spread is seen as the benchmark for overall credit and liquidity conditions in the interbank market since it represents the premium paid to borrow funds in the LIBOR market versus the more secure overnight market.It also embodies a term premium, as 3-month LIBOR is compared with expectations for compounded overnight rates. Market participants can hedge against, or express a view on, future moves in LIBOR/OIS by combining an FRA trade with a forward-starting OIS position.The spread is a direct function of credit quality of financial institutions. A long FRA/OIS spread position provides a hedge against deterioration of bank credit quality. This allows an investor to gain exposure to 3-month LIBOR/OIS, which increases with worsening bank credit quality.<G135>This graph shows the correlation of the 3rd IMM FRA/OIS with the 5-year bank CDS. The FRA/OIS moves in much the same direction as the bank CDS, indicating that as bank credit quality deteriorates the FRA/OIS spread widens.
- #21 FRA/OIS is quoted as a spread in basis points. In a hedge, the investor is long the spread. He takes a long position in the FRA and a short position in a forward starting OIS. For example a long position in the 3 BY 6 spread, the investor agrees with a FRA counterparty to lock today into a fixed rate to borrow money that will take place in three month time (effectively settling an interest payment based on a fixed rate and receiving a floating payment tied to Libor taken two business days before settlement). Simultaneously, he agrees to settle a payment with a swap counterparty in 6 months time which reflects the difference between an agreed fixed rate and a rate accrued from the overnight rate compounded daily for three months. Thus, the net exposure is based on current levels of 3-month FRA and OIS rates, three months forward. With the fixed rates already determined, the variable pay-off is then [3mL - 3mOIS-spread], which will result in higher pay-offs with worsening bank credit quality.Both legs of the trade cover the same notional amount. It is not exchange and simply represents the nominal amount used to determine the size of the interest payment. The FRA leg usesactual/360,the payment isbased on the Libor fixing set two bus days prior to the settlement date. The OIS uses actual/360 (on fixed and floating legs), with the payment occurring two business days after the maturity date. [IMM FRA/OIS is quoted from one quarterly IMM date reference to the next (they cover the same period as the quarterly ED futures contracts).]
- #23 SHOW <G134>FRA/OIS can also be used to express a directional view on credit spreads. During 2007 and 2008, as the banking crisis unfolded, LIBOR/OIS widened significantly and remained at elevated levels until measures by the governments and central banks helped credit conditions to normalize. Tensions resurfaced in Europe from May of last year driven primarily by negative assessments of the sovereign debt of Greece, Portugal, Ireland and Spain fueled by concerns on their government to sustain their fiscal positions and ability to make the payment of their maturity debt. The crisis spread to the banking sector as banks domiciled in those countries continued to experience limited access in the private overnight market and rely on Central Bank money. The EURIBOR/OIS spread reached a high on December 20th 2010 at 45 bps. The FRA/OIS structure could have been used to express this view. If I had anticipated that the spread would have come up more quickly than those anticipated by the forwards at the end of March, I could have bought the 9x12 spread, effectively buying the 9x12 FRA and selling the 9x12 OIS with the same start and end date. The trade would have resulted in a profit. Let’s check how much we would have made. You can see on this graph that the realized 3 month EURIBOR/OIS was higher than the anticipated forwards from October until January 2011 as it is often the case when the spread increases. 9 month from the trade date, the 3 month EURIBOR/OIS was 26 bps, resulting in a P&L of 19 bps at settlement. Setting up the trade on SWPM1. Find the instruments<WCV> EUSW0912 curncyEUFR0I1 curncySettlement March 22<SWPM>ConclusionWith the uncertainty surrounding the debt plan for Greece at this time, the large stakes of some European Banks in Greece either through direct holdings of government bonds or credit granted to the private sector, may prove detrimental to their credit standing. The FRA/OIS is one of the trades to hedge against the potential impact of various scenarios of the Greek Government debt on the profitability, capital and funding positions of these banks.As a word of caution, be aware, that short FRA/OIS positions are also used to hedged against widening of swap spreads which represents the difference between swap rates and government bond yields, another gauge for counterparty risk. So the FRA/OIS spread may move in the opposite direction as it has been the case since December 2010. I hope we have shed some lights on this important part of the front end trading and provided a platform that will help you guide our customers through the pricing and valuation of this trade more effectively.