Scenario-analysis, with approximate probabilities, may be presented to show impact of unattractive scenarios on company s financial performance.

Transcription

1 Managiing IIntterestt Ratte Exposure Naatturree off intteerreesstt i rraattee eexxpossurree US company borrows $100 million for 5 3-m Libor+100bps. Reminder: Libor rate used to fix coupon is observed at 11AM London time, 2 business days before beginning of interest period. Payment of interest occurs on last day of that period. On day 1, borrower knows exactly what interest payment will be at end of first interest period, but not that of any subsequent period. Interest rate (IR) exposure can be depicted via graph where: x-axis: Libor spot reset rate and y-axis: exposure = annualized interest cost of loan including credit spread or annualized interest revenue in case of investor holding Libor-based instrument, e.g. FRN. Exposure under loan Exposure under FRN investment Libor reset Coupon if loan / if investment Libor reset Coupon if loan / if investment. Reasonable range for x-axis: current spot Libor level ± 2 sigma (standard deviations): this represents around 95% of possible scenarios Scenario-analysis, with approximate probabilities, may be presented to show impact of unattractive scenarios on company s financial performance. Important assumptions should be clearly mentioned, with statement that many calculations are based on financial models known mentioned to be inaccurate to some degree and frequently evolving. Illustration: Consider a $100 million, 5-yr 3-m Libor+100bps. In all graphs, straight diagonal dark-blue line represents unhedged profile, with annualized IR expense increasing linearly with Libor resets. 1

2 Assume steep Libor curve with spot at 5%, and use vol of 15% for all caps and floors regardless of their moneyness level 1. Intteerreesstt I rraattee % Simplest of all interest rate hedges. Results in company locking in fixed interest expense for entire tenor of loan. On each settlement date, company pays Libor + 1% under loan, and receives under swap Libor %. Pay fixed/receive floating swap position Simultaneous purchase of cap financed solely by a Sale of floor with same strike. This strike equals exactly swap rate. All other structures simply change these building blocks to tailor solutions that reflect a specific market view. Interest Expense Hedged with Simple and easy to implement Full protection against Libor above swap rate Potential opportunity cost if Libor 1 In reality volatility is not symmetrical for caps and floors and is usually higher for options with lower strike levels. This volatility skew is discussed in detail in other modules. 2

3 Heedgi ing witth plaai in vvaani illaa Caapss s expose the company to opportunity costs. Solution may be purchase of plain vanilla caps. Company is hedged if Libor, while retaining full participation in favorable Libor moves ( ). Drawback: company pays upfront premium. 7% Cap 8% Cap Full protection if Libor Full participation if Libor Upfront premium In high vol environment, Libor must significantly to beat swap strategy and recover upfront premium Frrom sswaap tto ccol llaarr Change building blocks of our IR swap: Cap strike floor strike create IR collar. If premium of purchased cap = premium of sold floor zero-premium collar. Graph presents zero-premium collar next to IR swap strategy. 5% % Collar Full protection if Libor > cap strike Participation in favorable Libor moves down to floor strike Can be tailored to specific market view More remote protection level than under swap Potential opportunity cost if Libor < floor strike 3

4 Frrom ccol llaarr tto sseeaagul lll Company wants to improve participation level versus collar, and doubts Libor will significantly over life of loan: Company is willing to sell deep OTM cap and Use premium to improve floor strike. Strategy is known as short-vega seagull (SVS); company sells two options and buys one. Suppose now that company cannot tolerate significant opportunity costs if Libor significantly. In this case: Propose to make collar slightly OTM and use premium to buy deep OTM floor. Strategy is known as long-vega seagull (LVS): company buys two options and sells one. Collar Short vega seagull Long vega seagull Compared to zero-premium collar Better participation level versus collar for SVS For LVS, partial participation if Libor significantly Higher protection level versus collar for LVS Partial protection for SVS if Libor significantly Frrom ccol llaarr tto paarrtti icci ipaattorr fforrwaarrd Participator forwards are strategies that work best when yield curve is inverted rather than upward sloping as in prior examples. Return to collar illustration and suppose that: Company wants to improve protection level and is willing to share benefit of favorable moves in Libor. Company is happy with current Libor, which is > swap rate since curve is inverted. Since premium of floor with strike = spot Libor is significantly > premium of cap with same strike, company needs to sell floor on mere fraction of notional of bought cap. Combination is known as participator forward or participator swap. Participator Significant participation if Libor Can be tailored for different protection levels More remote protection level than simple IR swap Works mainly when curve is inverted 4

5 Frrom ccol llaarr tto leevveerraageed l ccol llaarr Reverting again to zero-premium collar, suppose that: Company wants to improve its protection level and has strong view that Libor will. Propose to modify collar structure and let company increase notional of sold OTM floor by multiplying original notional by factor n. This helps improve strike level of cap and hence protection level as required. Structure is known as nx1-leveraged collar; relatively risky compared to previous structures, with risk increasing with n. Graph below depicts 3x1-leveraged collar, along with forward and zero-premium collar. Protection level has improved, but risk increases significantly if Libor < strike of sold floors. Collar 3x1 leveraged collar Improved protection level Full participation in Libor declines until floor strike Significant risk if Libor < floor strike Insstti I ittutti ionaal l guideel lineess fforr ssaal leess off ccompl leexx prroduccttss Highly complex leveraged structures have sometimes caused very bad losses for corporate clients. Banks have therefore implemented appropriateness and suitability guidelines that are closely monitored by compliance departments. These include: Avoid sales altogether to unsophisticated or financially weak customers Obtain approval from higher level of authority before transacting, both internally and inside customer hierarchy Inculcate sales force culture of honesty in disclosure, fair dealing with customers, and use of explanatory tables and graphs in addition to text and legal documentation Provide frank and honest disclosure of risks and outcomes under downside scenarios 5

6 Liborr--i in--aarrrreeaarrss ((LI IA)) ssttrraatteegi ieess LIA swaps: identical to regular IR swaps, except that calculation (or fixing ) of Libor for each period is based on reset 2 business days before end of that period as opposed to 2 business days before its beginning under regular IR swap. With upward-sloping Libor curve, party that enters a basis swap, under which he pays LIA while receiving regular Libor in advance, is entitled to upfront premium, assuming all other features of swap are standard. Rather than being paid upfront, premium is used in a number of sophisticated hedging structures to improve economics: Purchase cap on LIA that Company is required to pay under basis swap, while receiving Libor in advance, which matches Libor under loan. Premium can also be used to improve features of zero-premium collar, e.g. improving protection level or participation level or both. Subssi idizzeed sswaap ssttrraatteegyy Structured by combining: Regular swap under which borrower pays fixed and receives Libor, with Short cap whose premium is not collected upfront but spread over swap s life. Suitable for borrowers that can tolerate flexibility on fixed-to-floating ratio of aggregate debt; enables them to: Pay reduced fixed rate, in return for risking that If Libor > a pre-defined level on any reset date, they revert to paying floating for that period, but at negative spread to prevailing Libor. Subsidized swap1 Subsidized swap2 Improved protection level compared to regular swap Negative spread to Libor when switches to floating Potential opportunity cost versus unhedged profile if Libor Potential opportunity cost versus regular swap if Libor Caancceel laabl lee sswaap ssttrraatteegyy In all respects a regular IR swap, in which borrower pays fixed and receives Libor, but may be canceled by bank at certain point(s) in future. Cancelable swap regular pay-fixed swap + short European or Bermudan payer swaption, causing fixed leg of cancelable swap to be < regular swap. Structure and pricing are examined in detail in module Callable Bonds and tions. 6