Introduction to Derivative Instruments Link n Learn. 25 October 2018

Transcription

1 Introduction to Derivative Instruments Link n Learn 25 October 2018

2 Speaker & Agenda Guillaume Ledure Senior Manager Advisory & Consulting, Capital Markets Deloitte Luxembourg Tel: Fabian De Keyn Director Advisory & Consulting, Capital Markets Deloitte Luxembourg Tel: Agenda Definition and use of derivatives Classification of derivatives Linear instruments Swaps Non-linear instruments Structured products Hybrid products Recent trends in derivatives markets OIS discounting Credit Valuation Adjustment Illustration: Swap trading in the past and nowadays 4 Conclusions and key messages 2

3 Definition and use of derivatives Contents Classification of derivatives Linear instruments Swaps Non-linear instruments Structured products Hybrid products Recent trends in derivatives markets OIS discounting Credit Valuation Adjustment Illustration: Swap trading in the past and nowadays Conclusions and key messages 3

4 Definition and use of derivatives Definition of derivatives A derivative can be defined as a financial instrument whose value depends on (or derives from) the value of other basic underlying variables (e.g. stocks, bonds, commodities ) Derivatives themselves can be traded on organized markets, or alternatively agreedupon between two counterparties ( overthe-counter or OTC transactions) Organized market: a derivative has a market observable price OTC: a derivative has no observable price, but a value that can be computed using a model The uses of derivatives can be split in three different categories (see chart on the right-hand side): Hedging Speculation Arbitrage 4

5 Definition and use of derivatives Contents Classification of derivatives Linear instruments Swaps Non-linear instruments Structured products Hybrid products Recent trends in derivatives markets OIS discounting Credit Valuation Adjustment Illustration: Swap trading in the past and nowadays Conclusions and key messages 5

6 Classification of Derivatives Derivative instruments can be split into 5 major families Their technical complexity is increasing but each of them can still lead to financial disasters if manipulated without care Hybrid Products Structured Products Linear Value of these products is linearly related to their underlying OTC or exchange-traded (with clearing house) 5 Provide a leverage with limited investment Swaps Usually OTC contracts that exchange two series of cash flows over a period in the future Cash flows can be fixed, floating, in various currencies Cash flows can be conditional on certain events Non Linear Products Typically any kind of options Value of the products evolves non-linearly with the value of the underlying OTC or exchangetraded Combination of options can lead to specific strategies Issued by a Bank Structured on two different products: Bond to provide full or partial protection Derivative (e.g. option) to increase performance OTC product (ad-hoc payoff) Built on investor s needs that are not covered by standard products Enable personal investors to take exposures they would usually have no access to Products that constitute a mix of several exposures More than just the sum of several components Example: convertible bonds that may behave as a bond or as an equity following the market conditions 6

7 Classification of Derivatives Linear Instruments Linear products are instruments that see their value directly related to the market price of the underlying variable In case of a move in the underlying asset, the value of the derivative will move with a nearly identical quantity Often called Delta-One products because there is a 1:1 relationship between the values of the underlying and derivative in case of market move Such products are not particularly complex mathematically but they may still provide high leverage and give exposure to high risks Futures Contract Forward Exchange Contract Contract For Difference (CFD) 7

8 Linear Instruments Futures Contract Bilateral contract in which two counterparties agree to buy/sell an underlying at a predetermined price at a specified date in the future Futures are traded on organized markets (exchanges), so they are standardized contracts Buyer Intervenes as counterparty of all trades to mitigate counterparty credit risk Broker Clearing House Broker Both counterparties must contribute collateral when entering into the trade (initial margin) Afterwards, the counterparty with negative MtM must contribute daily margin calls Seller Seller 8

9 Linear Instruments Forward Exchange Contract This sounds familiar! Bilateral contract in which two counterparties agree to buy/sell an underlying at a predetermined price at a specified date in the future Contrarily to Futures, Forwards contracts are Over-The-Counter ( OTC ) instruments traded directly between two counterparties Buyer No clearing house (no intermediary) between the counterparties No initial margin, no margin call Both counterparties are potentially subject to counterparty credit risk In practice, only the one with a positive MtM supports the credit risk Seller Seller 9

10 Swaps Swap contracts consist in the exchange by two counterparties of two streams of cash flows (legs) at future dates Nowadays, swaps represent the biggest part of global derivatives volumes Swaps are usually traded OTC, so share the following characteristics with forwards Can be highly customizable Subject to counterparty credit risk Main categories of swaps Interest Rate Swap (incl. Cross- Currency) Credit Default Swap Total Return Swap 10

11 Swaps Interest Rate Swap and Cross-Currency Swap IRS example 2% 10,000,000 = EUR 200,000, paid every year Party A Party B Libor6M % 6 10,000,000, paid every 6 12 months following fixing of the Libor6M rate CCIRS example JPY 130,000,000 Party A Party B Party A Party B Party A Party B (JPYLIBOR6M + Spread) x 6 12 x 130,000,000 Paid semi-annually 11

12 Swaps Valuation: Discounted Cash Flows Method IRS: notional of 10,000,000 EUR, 3-year maturity, fixed rate 1% versus EURIBOR12M An IRS can be viewed as a strategy involving a pair of securities: Fixed Rate leg: Purchase of a fixed rate note ("Bond") for EUR 10,000,000 paying annual fixed interest and receiving principal at maturity Floating Rate leg: Sale of a floating rate note paying floating annual interest (EURIBOR12M) and repaying principal at maturity notional EURIBOR12M 1y Floating Leg Pay Floating EUR -1,9K Pay Floating EUR??? Pay Floating EUR??? Fixed Leg Dec17 Valuation date Dec18 Dec19 Dec20 Receive Fixed EUR 100K Receive Fixed EUR 100K Receive Fixed EUR 100K Time notional 1% 1y 12

13 Swaps Valuation: Discounted Cash Flows Method Step 1: Estimation of the forward rate from zero coupon yield curve R 1 f 1,1 f 2,1 f1,1 = 0, 03% f 2,1 = 0, 43% Dec17 Dec18 Dec19 Dec20 R 2 R 3 Bloomberg Interest Rates Curve Floating Leg Pay Floating EUR -1,9K Pay Floating EUR 0,3K Pay Floating EUR 4,3K Fixed Leg Dec17 Valuation date Dec18 Dec19 Dec20 Receive Fixed EUR 100K Receive Fixed EUR 100K Receive Fixed EUR 100K Time 13

14 Swaps Valuation: Discounted Cash Flows Method Step 2: Discounting the future cash flows (cf. time value of money) PV of cash-flow Cash-flow 0 T Discounting Factor Bloomberg Interest Rates Curve Floating Leg Pay Floating EUR -1,9K Pay Floating EUR 0,3K Pay Floating EUR 4,3K Fixed Leg Dec17 Valuation date Dec18 Dec19 Dec20 Receive Fixed EUR 100K Receive Fixed EUR 100K Receive Fixed EUR 100K Time Swap value = 1,9K + 100K DF 1 + 0,3K + 100K DF 2 + ( 4,3K + 100K) DF

15 Swaps Credit Default Swap A Credit Default Swap (CDS) is some kind of insurance contract One party pays a premium leg (fixed or floating) to obtain protection against the default of a reference asset Objective: transfer the credit risk exposure of the reference asset from the risk-averse party to the protection seller 1 Investment Reference asset (Bond) Protection buyer 2 Pays premium Pays regular payments to the seller until maturity or default Protection seller At contract date Scenario 1 The reference bond performs without default Scenario 2 The reference bond defaults 1 Pays par value of the Bond Protection buyer Protection seller Protection buyer Protection seller The buyer loses the premium and receives bond performance 2 Delivery of Bond Reference bond Reference bond 15

16 Swaps Total Return Swap A Total Return Swap (TRS) exchanges two streams of cash flows A total return leg that pays cash flows corresponding to the total return on the period of a specified asset (including any capital appreciation/depreciation and interest/coupon payments) A premium leg that pays cash flows indexed on a fixed rate or floating rate index No notional exchange at maturity of the swap Objective: transfer the total economic exposure (market and credit risk) of the reference asset without having to purchase or sell it 1 Pays: Libor + Spread Payer of Total Return Total Return (Performance of the reference asset) Receiver of Total Return Purchase Total Return Reference asset (Bond, Index, Equity, Fx rate, Commodity) 16

17 Non-Linear Instruments Non-linear products are instruments that see their value related to the market price of the underlying variable, but under a non-linear relationship The payoff of such products varies with the value of the underlying, but also with other elements (interest rates, volatility, dividends, etc.) Non-linear products are often referred to as options but this is a global name for a wide range of different payoffs Vanilla European option Vanilla American option Bermudan option Exotic options (Asian,Digital, Barrier) etc. Various underlying assets: stocks, indices, funds, fx rate, interest rates, bonds, etc. These products can be exchange-traded or OTC 17

18 Non-Linear Instruments Vanilla Options Definition: The right to buy/sell an underlying asset at a certain price at a future maturity date European vanilla options: positive payoff if the underlying value at maturity is higher/lower than a specified value (strike) and 0 otherwise Call option: payoff = max(0, S T K) Put option: payoff = max(0, K S T ) To enter into an option, a certain premium must be paid by the option purchaser P&L profile of vanilla options Call Put Buyer Profit Seller Spot Price Exercise Price Exercise Price 18

19 Non-Linear Instruments Vanilla Options Profile of the option s P&L (MtM premium) and impact of time to maturity Increase in time to maturity Payoff Maturity=1Y Maturity=3Y Maturity=5Y 19

20 Vanilla Options Time Value Let s assume that a call option has these characteristics: Strike is 100 USD Underlying spot price is 90 USD Maturity is 1 year (assume no rates, no dividends for simplicity) Intrinsic value What is the option value? Time value Option value = Intrinsic Value + Time Value The payout if the option were maturing immediately The additional premium due to the remaining time-tomaturity of the option Option value Spot Price 20

21 Vanilla Options Volatility Volatility is a measure of dispersion of the price of the underlying asset around the trend Two assets may exhibit different levels of volatility Microsoft / SP500 Index (source: Bloomberg) 21

22 Vanilla Options Impact of Volatility An increase in volatility leads to an increase of the option value due to the higher probability to get a high payoff for a given date In case of decrease of the underlying: a higher volatility leads to a stronger fall, but no loss for the call holder In case of increase of the underlying: a higher volatility leads to a stronger rise, so a higher profit for the call holder The call value increases with volatility! Increase in volatility Payoff Volatility=10% Volatility=20% Volatility=30% 22

23 Vanilla Options Valuation Assume we want to value a call option on a stock that will pay a certain cash flow only if the stock price matures above a certain level K The payoff at maturity can be written as follows: max S T K, 0 The value of the option will equal: Value Option = E[max S T K, 0 DF T ] The critical aspect is to determine what is the probability distribution of S T, i.e. the different possible values of S T and their respective probabilities For that purpose, make use of a model! For instance, the famous Black-Scholes formula enables to value vanilla calls and puts: European Call value = function(spot price, strike, volatility, time to maturity, dividend yield, risk free rate) 23

24 Vanilla Options Valuation with Monte Carlo simulations Given a model, you can compute the expectation E using a numerical method like the Monte Carlo simulation Steps to follow 1. Simulate the random walk from the valuation date to maturity date 2. Calculate the option payoff for this simulation 3. Repeat the steps 1 and 2 (a lot of times) 4. Calculate the average payoff of all simulations 5. Take the present value of this average ,2 0,4 0,6 0,8 1 24

25 Structured Products Structured products are financial instruments that are the result of the combination of several basic instruments, all wrapped together to provide specific payoffs and exposures Credit Linked Products This family covers products such as ABSs, MBSs, CDOs, CLOs, CLNs Capital- Guaranteed Products Callable Products Interest Rate products Capital-Guaranteed Products This family covers products that provide full reimbursement or at least some protection on the invested capital (airbag) Callable Products This family covers structured products that, at certain points in time, can be early terminated following the choice of one of the parties (issuer or noteholder) Interest Rates products This family covers products providing exposure on interest rates markets such as CMS products, snowball, range accruals,... Structured Products Auto-Callable Products This family covers products than might be early terminated automatically as soon as specific conditions are fulfilled. Examples cover Phoenix notes and all related 25

26 Hybrid Products A hybrid product combines several characteristics and may exhibit different behaviors according to the market conditions Typical example: convertible bond Behaves roughly like a bond (subject to interest and credit risk) if the underlying stock price is low Behaves roughly like an equity if the underlying stock price is high Fixed-income Hybrid Equity

27 Definition and use of derivatives Contents Classification of derivatives Linear instruments Swaps Non-linear instruments Structured products Hybrid products Recent trends in derivatives markets OIS discounting Credit Valuation Adjustment Illustration: Swap trading in the past and nowadays Conclusions and key messages 27

28 Recent Trends in Derivatives Markets Summary DERIVATIVES (SWAPS) VALUATION TRANSPARENCY COUNTERPARTY CREDIT RISK 28

29 OIS Discounting Counterparty credit risk Counterparty credit risk The risk that an entity with whom one has entered into a financial contract (the counterparty) will fail to fulfil their side of the contractual agreement Counterparty risk is typically defined as arising from two broad classes of financial products: Securities financing transactions e.g. repos and reverse repos and securities borrowing and lending OTC derivatives including interest rate swaps, FX forwards and credit default swaps How to deal with counterparty credit risk in derivatives valuation? Require the party with negative MtM to post collateral in guarantee in case it goes into default Adjust the valuation to incorporate credit exposure By far the most significant class due to the size and diversity of OTC market Collateral management can be burdensome and introduce operational risk 29

30 OIS Discounting Before the credit crisis 1 Libor, the short-term borrowing rate of AA-rated banks was seen as a proxy for the risk-free rate Counterparty credit risk was a minor concern and collateral agreements were far from systematic Yield curves calibrated on instruments of any tenor were more or less identical Consequences on swap valuation 2 A yield curve calibrated on the market prices of the most usual liquid swaps was used to forecast floating cash flows The same curve was used to discount cash flows when the swap was collateralized or when the counterparty was sufficiently solid (i.e. well-rated) Before the credit crisis, valuation was performed in a Single-Curve Framework 30

31 OIS Discounting During the credit crisis The onset of the crisis (esp. the collapse of Lehman) raised questions about the liquidity and creditworthiness of big banks, even well-rated: Regulators and public opinion called for increased transparency and regulation of OTC markets Collateralization with daily margin calls became a necessity Strong criticism of LIBOR as fair and risk-free reference rate LIBOR, the rate of unsecured borrowing, denoted the risk of AA-rated banks, but no more the absence of counterparty credit risk Suspected manipulations of the LIBOR fixing procedures led to a distrust of LIBOR LIBOR6M was riskier than LIBOR3M, itself riskier than LIBOR1M, etc. Central banks continued to provide abundant liquidity via their bank lending window Fed funds ( cash ) and short-dated T-Bills were the sole remaining assets considered as more or less free of credit risk, since dealt with highest-quality government entities and for the shortest maturity (1-day) These short-dated risk-free assets were the only acceptable deliverable assets for collateral maintenance 31

32 OIS Discounting Consequences of the credit crisis on valuation Behaviours of dealers on swap markets changed dramatically: Apparition of non-negligible tenor basis Large differences between yield curves calibrated on instruments of different tenors Consequences on swap valuation: Sub-prime crisis ( ) Euro sovereign debt crisis ( ) Forecasting floating cash flows requires the use of the yield curve calibrated on instruments of the corresponding tenor Discounting cash flows of collateralized swaps requires the use of a risk-free yield curve Start Mid-2007 Best proxy: a curve calibrated on instruments with a 1D tenor (i.e. Overnight- Indexed Swaps ), the OIS curve 3M EUR LIBOR-OIS spread Close to 0 until credit crisis Since the credit crisis, valuation is performed in a Multi-Curve Framework, with discounting under the OIS curve, considered as an almost risk-free curve 32

33 OIS Discounting Multi-curve framework An Overnight-Indexed Swap can be valued under a Single-Curve framework This enables to calibrate this OIS curve using liquid OISs An Overnight-Indexed Swap is a fixed-floating IRS where the floating rate is calculated using the daily compounded overnight rate index Effective federal funds rate in USD, Euro Overnight Index Average (EONIA) in EUR, Sterling Overnight Index Average (SONIA) in GBP, etc. Forecasting the floating rate of a non-liquid OIS requires a curve calibrated on a 1D tenor (i.e. liquid OISs) Discounting collateralized cash flows requires the riskfree curve, i.e. the curve calibrated on liquid OISs For collateralized regular IRSs (e.g. in EUR: 1Y fixed vs. EURIBOR6M), two curves are necessary The OIS curve calibrated beforehand as above to discount the cash flows The LIBOR6M curve, i.e. a curve calibrated using liquid swaps indexed on LIBOR6M Regular IRSs need to be valued under a Dual-Curve framework with OIS discounting The multiplicity of tenors (1D, 1M, 3M, 6M) results in the Multi-Curve framework Valuation results may be very different than in the pre-crisis Single-Curve world 33

34 OIS Discounting Issues of the multi-curve framework Reporting issues The transition from LIBOR to OIS curves may cause large portfolio MTM changes resulting in greater income statement volatility Hedge accounting: hedge may prove less effective (or fail hedge effectiveness test) if e.g. hedge is discounted at OIS while the hedged item is not Active OIS markets do no exist for all currencies and may be limited to short to medium-term maturities (which makes it difficult to calibrate a complete discounting yield curve) Calibration of all yield curves should be a fully integrated process, since swaps used as calibration instruments have influence of several curves, especially when dealing with cross-currency swaps Discounting using a LIBOR yield curve (represents a standard AA-rated banking counterparty)? Practical valuation issues Open debate: how to discount uncollateralized trades? Discounting using the OIS yield curve shifted by some credit spread (depending on the counterparty)? Discounting using the OIS yield curve and account for valuation adjustments? No market consensus so far 34

35 Recent Trends in Derivatives Markets Summary Since the crisis, rate of collateralized Overnight-Indexed Swaps is seen as the true riskfree rate instead of LIBOR DERIVATIVES (SWAPS) VALUATION Sub-prime crisis ( ) Euro sovereign debt crisis ( ) Incorporation of new market realities into pricing Multi-curve framework (depending on collateralization) The yield curve built upon OIS is the new standard for discounting Start Mid M EUR LIBOR-OIS spread Close to 0 until credit crisis Challenges of collateral include the operational costs, the complex management of threshold and netting agreements, the determination of cheapest-to-deliver assets, etc. TRANSPARENCY COUNTERPARTY CREDIT RISK Essential to know precisely the exposures of the bank with respect to each individual counterparty High standards of transparency to guarantee investors protection and best execution within MiFID; Benchmark regulation Importance of proper collateral management Inclusion of Credit Support Annexes (CSA) in swap contracts 35

36 Credit Valuation Adjustment Quantification of credit risk Traditional management methods of counterparty risk tend to work in a binary fashion: For example the use of a credit limit if the limit is breached, financial institution would refuse to enter into a transaction Problem with this is that only the risk of a new transaction is being considered but potential profit of the new transaction should also be a factor in the decision making process By pricing counterparty risk, one can move beyond a binary decision making process : The question of whether to enter a transaction becomes simply whether or not it is profitable once the counterparty risk component has been priced in In other words we adopt the following equation: Risky price = Risk-free price + CVA Credit Valuation Adjustment = Price of counterparty risk Price assuming no counterparty risk 36

37 Credit Valuation Adjustment Quantification of credit risk CVA = Present Value[Loss in case of counterparty default Probability of default] = (1-Recovery rate) Exposure at default Probability of default Discount Factor Credit Valuation Adjustment The transaction type i.e. is it an interest rate swap or an FX forward Whether there are other offsetting positions with the counterparty that will result in a netting effect (and is there a netting agreement for this to apply) Whether of not the transaction is collateralised Any hedging aspects of the underlying transaction 37

38 Credit Valuation Adjustment Challenges CVA valuation methodologies are still not standardised: Can range from relatively simple to highly complex methods Methodology used largely driven by sophistication and resources available to market participant Depending on a particular participant, CVA can be quite large Standardisation 1 Common challenge for all entities computing CVA is obtaining the necessary market data: Requires some degree of judgement in coming up with proxy data in order to compute CVA Whether or not credit spreads are available Market Data 2 Regardless of methodology used to compute CVA, a certain level of expertise and management judgment is required to ensure that CVA has been considered and appropriately applied Skills 3 38

39 Recent Trends in Derivatives Markets Summary Since the crisis, rate of collateralized Overnight-Indexed Swaps is seen as the true riskfree rate instead of LIBOR DERIVATIVES (SWAPS) VALUATION Sub-prime crisis ( ) Euro sovereign debt crisis ( ) Incorporation of new market realities into pricing Multi-curve framework (depending on collateralization) The yield curve built upon OIS is the new standard for discounting Start Mid M EUR LIBOR-OIS spread Close to 0 until credit crisis Challenges of collateral include the operational costs, the complex management of threshold and netting agreements, the determination of cheapest-to-deliver assets, etc. TRANSPARENCY COUNTERPARTY CREDIT RISK Essential to know precisely the exposures of the bank with respect to each individual counterparty High standards of transparency to guarantee investors protection and best execution within MiFID VALUATION ADJUSTMENTS CVA (Credit) accounts for the counterparty credit risk if no collateral Importance of proper collateral management Inclusion of Credit Support Annexes (CSA) in swap contracts Inclusion of proper valuation adjustments DVA (Debit) accounts for own counterparty credit risk if no collateral 39

40 Illustration: Swap trading in the past and nowadays Example of cross-currency swap and after the crisis Before the 2007 crisis Classical valuation framework Two yield curves are required: - 1 single standard curve for forecast and discount in ccy1-1 single standard curve for forecast and discount in ccy2 Multi-curve valuation framework Four yield curves are required: 1 forecast curve in ccy1 corresponding to the right LIBOR tenor 1 discount curve in ccy1: - OIS if collateralized - Standard Libor curve otherwise 1 forecast curve in ccy2 corresponding to the right LIBOR tenor 1 discount curve in ccy1: - OIS if collateralized - Standard LIBOR curve otherwise - Cross-currency and maybe tenor basis adjustments Ccy1 is the collateral currency, ccy2 is the other one! Regulatory and practical obligations Report to a trade repository (EMIR) Ensure there is a Credit Support Annex for collateral definition and practical details Fulfil MiFID transparency obligations Collateral management: operations, netting agreement, thresholds, etc. If not collateralized trade: - Compute CVA/DVA - Take netting into account - Consider other trades in portfolio 40

41 Definition and use of derivatives Contents Classification of derivatives Linear instruments Swaps Non-linear instruments Structured products Hybrid products Recent trends in derivatives markets OIS discounting Credit Valuation Adjustment Illustration: Swap trading in the past and nowadays Conclusions and key messages 41

42 Key Messages 1 Definition and use of derivatives A financial instrument whose value depends on (or derives from) the value of other basic underlying variables Derivatives may be used for hedging, speculation or arbitrage, but always as a mean to transfer risk exposure 2 Derivatives can be classified in 5 categories: Linear instruments: essentially Futures and Forwards Swaps, valued under the Discounted Cash Flows methodology Non-linear instruments: essentially options Structured products Hybrid products 3 Increased care for transparency and management of credit risk have led to new valuation techniques, even for instruments as simple as IRSs Multi-curve valuation framework (with OIS discounting) Inclusion of valuation adjustments such as CVA and DVA 42

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44 Next Link n Learn - Thursday 8 th November Topic RPA (Robotics) in the Investment Management Industry

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