UNDERSTANDING AND MANAGING OPTION RISK

Transcription

1 UNDERSTANDING AND MANAGING OPTION RISK Daniel J. Dwyer Managing Principal Dwyer Capital Strategies L.L.C. Bloomington, MN August 9 & 10, 2018

2 Dwyer Capital Strategies L.L.C. Financial Institution Advisory Services Understanding and Managing Option Risk Daniel J. Dwyer Managing Principal Bloomington, MN By: Daniel J. Dwyer Principal

3 Introduction What the course expects to convey: An overview of "Optionality", and the influence on daily financial management A broader discussion of derivative-based products and strategies - and the implications to balance sheet management The concepts of structuring and applying options to protect net interest margin from interest rate risk The concept of options as insurance policies that can help an institution manage its Economic Value of Equity (EVE/NEV) metrics Specific examples of macro-level swap/option strategies utilized by financial institutions Creative "facility-level" pricing strategies utilizing options to benefit the borrower and organization High-level overview of the broader capital markets, and the theory behind the pricing of such strategies - Calculating actual costs to implementation Discussion of the risks associated with these option-based strategies, and a look at documentation and due-diligence required 2

4 Types of Interest Rate Risk Components of Interest Rate Risk (Per the Federal Reserve Bank*) Interest Rate Risk Repricing Risk Basis Risk Yield Curve Risk Embedded Option Risk *(See Basel Committee on Banking Supervision (BCBS) 2003) 3

5 Interest Rate Risk and Optionality Components of Interest Rate Risk Optionality (Option Risk) Optionality : Refers to risks arising from interest rate options embedded in a bank assets, liabilities, and off balance-sheet positions Such options can be explicitly purchased from established markets (such as) interest rate derivatives or included as a term within a loan contract, such as the prepayment option included in residential mortgages Taken from FRBSF Economic Letter September 17, 2004 Jose A. Lopez 4

6 Optionality Optionality = An embedded rule in the terms of the instrument that allows for a change in cashflow characteristics. Auto Loan Amount = $10,000 Rate = 3 Month Libor - Floating (Currently 1.20%) %* Maturity = 4 Years * Interest Rate has a contractual Floor of 2.50%* Fixed Rate CD Amount = $10,000 Rate = 2.00%* Maturity = 4 Years *Purchaser is allowed a 1-Time Rate increase 5

7 Types of Optionality Options = Arbitrary Changes in a Cashflow Call Option Put Option Cancel Option Rate Step Option Prepay Option Mortgage Pool Cashflow (CMO) Inverse Floating Option Floating Loan Cap Rates Wholesale Funding Call / Put Trust Preferred variability 6

8 Derivatives - Applications Financial Derivative/Option Uses for Financial Institutions: Modifying Cashflows An Asset/Liability Manager s primary function is to manage the institution s cashflows. In fact, the reasonable expectation of cashflows constitutes the primary driver to an institution s profitability. 7

9 Where is Optionality Found? As we established, modifying cashflows is the primary function of financial derivatives. On a daily basis, what decisions are based on cashflows? Loans Investments Deposits Wholesale Funding Capital Each additional earning asset or IBL applied to the balance sheet has the potential to alter a bank s interest rate risk profile. These facilities are added on a daily basis. Therefore, knowing the bank s interest rate risk profile, (and how the derivatives marketplace can assist in minimizing risk) is valuable information to be used on a daily basis. 8

10 Managing Option Risk * Strategies * Organic vs. Synthetic Organic Strategies Synthetic Strategies Utilizing a like structured traditional facility to offset/cancel the option risk. EXAMPLE: Match-Fund a loan facility with a similarly structured funding source with like (offsetting) option features. Utilizing an Off Balance Sheet Derivative structure to Overlay the facility - negating the option risk. EXAMPLE: Engage an interest rate swap to Overlay a loan facility with opposite option characteristics 9

11 Managing Option Risk * Strengths and Weaknesses * Organic vs. Synthetic Organic Strategies Synthetic Strategies Utilizing a like structured traditional facility to offset/cancel the option risk. Strengths: Familiarity Easily Implemented Weaknesses: Lack of Customization Balance Sheet Implications (Debt / Equity Ratio) Utilizing an Off Balance Sheet Derivative structure to Overlay the facility - negating the option risk. Strengths: Highly Effective Balance Sheet Control Weaknesses: Sophistication Regulatory Implications 10

12 Managing Option Risk - Example * The Organic Strategy * Utilizing a like structured traditional facility to offset/cancel the option risk. EXAMPLE: Match-Fund a loan facility with a similarly structured funding source with like (offsetting) option features. Potential Risk Pool of Fixed Rate Loans Option Risk? = Option to Prepay! Option Risk Hedge FHLB Fixed Rate Advances Embed the Member Option (Borrower has the option to prepay the loan should rates be advantageous (Rates Fall, borrower has incentive to refinance.) ( Member Option is an embedded option that allows the User of the facility to cancel the advance without penalty.) If Loans Prepay Cancel the Match Funding! 11

13 Organic Strategy Implications * The Organic Strategy * Utilizing a like structured traditional facility to offset/cancel the option risk. EXAMPLE: Match-Fund a loan facility with a similarly structured funding source with like (offsetting) option features. Implications of Organic Strategies o o o o o Balance Sheet Size Changes Balance Sheet Capital / Liquidity Ratio Ramifications Option Price Inefficiency Lack of Customization Lack of Liquidity 12

14 Synthetic Strategy Off Balance Sheet * The Synthetic Strategy * Utilizing an Off Balance Sheet Derivative structure to Overlay the facility - Negating the option risk. EXAMPLE: Engage an interest rate swap to Overlay a loan facility with opposite optionality Advantages of Synthetic Strategies o o o o o Reduce Interest Rate and Option Risk Reduced Cost (Compared to Organic Strategies) Fully Customizable Minimal Balance Sheet Implications Highly Liquid 13

15 Applied Theory of the Hedging Index What Financial Institution Managers Need to Know 14

16 Understanding Reprcing The Repricing Index The metric by which interest payments are periodically adjusted. (The adjusted interest rate of an interest-sensitive asset or liability.) Most Common to Community Financial Institutions: Prime Rate Fed Funds (Federal Reserve Target) Libor CMT SIFMA / BMA 15

17 Current Markets Fed Target and 3 Month Libor (Swaps) correlate closely Prime maintains a historical spread to Libor / Fed Target of bps 16

18 Definitions Why are we talking about these indices? Fed Target Rate (Federal Funds Rate or - FDTR): The Fed Target Rate is the Theoretical short term (overnight) interest rate as set by the Federal Reserve s Open Market Committee (FOMC) as part of its monetary policy. The rate signifies theoretical overnight borrowing between the highest quality banks. (Typically set/adjusted 8X per year.) Libor (London Interbank offering rate): Actual average rate charged by/between highest quality banks to borrow overnight funds. Prime Rate: The rate that a commercial bank offers to its theoretical Most credit Worthy borrowers. Rate consistently is set at 300 bps above Fed Target, and moves in lockstep. 17

19 Historical Perspective A Note on Prime vs. Fed Target 18

20 Historical Perspective A Note on Fed Target vs. 3 Month Libor 19

21 Correlation of Indices Fed Target and 3 Month Libor (Swaps) correlate closely Prime maintains a historical spread to Libor / Fed Target of bps 20

22 Correlation of Indices Close Correlation Basis Risk Note the Exception to the Correlation Due to Dislocation of Markets in

23 Significance of 3-Month Libor Why are talking about 3-Month Libor??? - 3-Month Libor is an actual rate being charged for overnight borrowing between financial institutions. -Hedging against these overnight borrowing rates (Libor) is one of the largest and most liquid futures markets in the world. (90-Day Eurodollar Futures). In other words - We can use the Market-Based future path of Libor Rates to get an Equivalent Fixed rate. (i.e.. Fixed Swap Rate). 22

24 Significance of 3-Month Libor Why are talking about 3-Month Libor??? 3-Month Libor is the most widely used index for determining a Fixed Rate to be paid over time. (It also closely correlates to Fed Target and Prime.) In other words The Swap Rate is the fixed rate that receiver demands in exchange for the uncertainty of having to pay the short-term LIBOR (floating) rate over time. And Therefore Since Libor and Prime closely correlate, the Swaps market is an ideal tool to alter a facility s interest rate risk profile. 23

25 Significance of 3-Month Libor Libor 3 Month Libor 2005 Present Summer % October 10 th, % Jan % Summer 2008 ~2.75% Jan 2013 Oct % -.30% 24

26 Derivative Based Products The Marketplace and The Tools 25

27 Derivatives For this discussion An Interest Rate Derivative (Swap, Cap, Floor) is an exchange of interest flows without an exchange of principal The derivative is a wholly separate and distinct contract from the facility being hedged Completely customizable with flexible terms Payments are based upon a Notional amount of the swap (i.e. theoretical value upon which interest payments are calculated) Typically, one party pays a fixed rate of interest (or fixed payment), while the other pays a floating rate (or variable ongoing payments) Floating rate is benchmarked to some widely available index (usually 3-Month LIBOR) The exchange is affected by the net difference in payments from each party paying fixed or variable rates to the other 26

28 Derivatives - Relevant Tools For this discussion, we will focus on two types of interest rate derivatives that are used in managing Option Risk: Interest Rate Swaps An agreement between two parties to pay interest on an agreed-upon dollar amount (Notional Amount) for an agreed-upon period of time (Tenor). The difference lies in the characteristics of the interest payments. Typically, one party pays a fixed interest rate, while the other pays a floating rate based on a recognized index. Interest Rate Caps and Floors - (Interest Rate Options) The interest rate cap is an option product, functioning much like an "insurance policy. It protects the buyer against rising (falling) interest rates. It is purchased via a one-time, upfront premium. In return the seller agrees to reimburse the buyer should the index rate exceed the strike rate on the cap. 27

29 Options Formal Definition The formal definition of Interest Rate Options And the Subset (Caps / Floors) - are defined as follows: Interest Rate OPTIONS Purest Definition Interest rate options A SUB-CLASS OF DERIVATIVES - are offered on Treasury bond futures, Treasury note futures and Eurodollar (Libor) futures. An investor taking a long position in interest rate call options believes that interest rates will rise, while an investor taking a position in interest rate put options believes that interest rates will fall. Interest Rate CAP (Floor) Purest Definition An interest rate cap (floor) is actually a series of European interest call options (called caplets), with a particular interest rate, each of which expire on a specific date (reset). By definition, Options also include non-vanilla Swap structures Such as: o Swaptions o Cancelable Swaps o Swaption Straddles 28

30 Derivatives The Marketplace Source: Bank for International Settlements 29

31 Interest Rate Swaps 30

32 Swaps - A Typical Transaction Interest Rate Swaps An agreement between two parties to pay interest on an agreed-upon dollar amount (Notional Amount - Theoretical) for an agreed-upon period of time (Tenor). The difference lies in the characteristics of the interest payments. Typically, one party pays a fixed interest rate, while the other pays a floating rate based on a recognized index. By Swapping a fixed payment for a floating receipt, organization is more Asset Sensitive. 31

33 A Typical Swap Transaction The Swap An agreement between two parties to pay interest on an agreed-upon dollar amount (Notional Amount) for an agreed-upon period of time (Tenor). The difference lies in the characteristics of the interest payments. Typically, one party pays a fixed interest rate, while the other pays a floating rate based on a recognized index - i.e. Libor. Fixed Swap Rate Bank 3 Month Libor (Floating) Counterparty From an interest rate risk perspective, note how the Bank has just become more asset sensitive: Added a floating rate asset (receiving Libor floating) - and added a fixed rate liability (paying fixed). 32

34 Swaps - A Typical Transaction Reflected in the graph below, a Bank has elected to pay fixed in a swap contract. Given the forward LIBOR curve, or Swap curve, the fixed rate of 3.00% paid will initially be higher than the current floating 2.30% LIBOR rate received. But after some time, this fixed 3.0% will be lower than the floating rate. Profit Zone for Payer of Fixed Loss Zone for Payer of Fixed 33

35 Determining the Fixed Rate Determining the FIXED Swap Rate: At the time of the swap agreement, the total value of the swap s fixed rate flows will be equal to the value of expected floating rate payments implied by the forward LIBOR curve. As forward expectations for LIBOR change, so will the fixed rate that investors demand to enter into new swaps. Swaps are typically quoted in this fixed rate. 34

36 Liquidity Market Value All Transactions are considered a Liquid agreement Meaning that at any given time, a market value can be determined At any given time, there is either a positive or negative market value This market value is determined by the current LIBOR and swap rates As forward expectations for LIBOR change, so will the market value 35

37 Interest Rate Caps (Floors) 36

38 Interest Rate Cap Mechanics The interest rate cap is an option product, functioning much like an "insurance policy" It protects the buyer against rising short-term interest rates. It is purchased by the buyer via a one-time, upfront premium. In return the seller agrees to reimburse the buyer should the index rate exceed the strike rate on the cap: Provides a limit on the customer's effective interest rate Provides protection against rising rates without fixing the rate Buyer retains all of the benefits of declines in short term rates 37

39 Interest Rate Cap Mechanics The seller of the Cap makes a payment to the buyer when the short-term benchmark index rate (e.g. LIBOR) exceeds the Cap strike rate. If the index is equal to or below the strike rate of the Cap, there is no payment. If index rate is greater than the cap strike rate, buyer receives a payment from seller, Payment is equal to the rate differential on the contract amount over the number of days in that period. 38

40 Interest Rate Cap Mechanics The upfront premium is determined primarily by the following factors: Contract Notional Amount Theoretical dollar amount to be protected Tenor Term of the insurance contract Strike Rate The index rate that when exceeded, payments are remitted Implied Rate Volatility high volatility = high cost Shape and steepness of the swap curve The steeper the swap curve = The higher future Libor expectations = Higher cost 39

41 Interest Rate Cap Mechanics The cap functions as an interest rate insurance policy. In exchange for a one-time, up-front payment, the counterparty agrees to compensate the purchasing bank for the increment that the Index Rate rises above a chosen level ( the strike rate ). 8.50% 8.00% 7.50% 7.00% 6.50% 6.00% Payment to Cap Buyer 5.50% 5.00% 4.50% Cap Rate Rate Paid Potential Rate Scenario 40

42 A Typical CAP Transaction Sample of Upfront premiums for certain structures Based on $10 Million Notional Pricing as of May 29th, 2018 For informational Purposes Only 41

43 Rate and Price Determination 42

44 Swaps / Options - Determining the Pricing Determining the Cost of Hedge 1. The swap rate is the fixed interest rate that the receiver demands in exchange for the uncertainty of having to pay the short-term LIBOR (floating) rate over time. 2. The Cap/Floor s dollar price is determined by the sum dollar cost of each Caplet : 3. At any given time, the market s forecast of what LIBOR will be in the future is reflected in the forward LIBOR curve. 4. At the time a swap/option contract is put into place, it is theoretically priced at the money. Meaning that the total value of fixed interest-rate cash flows over the life of the swap is exactly equal to the expected value of floating interest-rate cash flows. Therefore, at the inception of the swap, the net present value, or sum of expected profits and losses, will theoretically add up to zero. 43

45 When Will Rates Rise? 90-Day Eurodollar Forward Curve - June 1st, 2018 (vs. June 1, 2017) 44

46 Swaps - Determining the Fixed Rate Plain Vanilla Swap Rates By Maturity (Based on Lib3M - As of May 29th, 2018) 45

47 Swaps - Determining the Fixed Rate The Swap Curve (Based on Lib3M - As of May 29 th, 2018) 46

48 Historical Perspective The Swap Curve The plot of swap rates across all available maturities is known as the swap curve. Swap rates incorporate a snapshot of the forward expectations for LIBOR Also reflects the market s perception of credit quality of generic AA-rated banks. 47

49 Historical Perspective The Swap Curve (2013 Present) 48

50 Historical Perspective The Swap Curve - Note the volatility! 49

51 Historical Perspective Libor 3 Month Libor vs. 5 Year Swaps Current - ~65 bps ~ bps 50

52 Current Derivative / Option-Based Ideas for Liability Sensitive Financial Institutions 51

53 Liability Sensitive Financial Institution The LIABILITY SENSITIVE INSTITUTION The client is liability sensitive, and concerned about a rising rate environment in the near term LIABILITY SENSITIVE INSTITUTION $ in 000's Detail regarding Repricing TOTAL Reprice Window 0-1 YEAR 1-2 YEAR 2-3 YEAR 3-4 YEAR 4-5 YEAR 5+ YEAR Due From/FF Sold 50,000 50,000 Investments 225,000 75,000 40,000 35,000 40,000 20,000 15,000 Loans 700, , , , ,000 75,000 65,000 Other 25,000 25,000 TOTAL 1,000, , , , ,000 95,000 80,000 Non-Mat Deposits 550, , , ,333 Fed Funds Purch 25,000 25,000 CD 300, ,000 65,000 70,000 35,000 25,000 Capital from TruPS 20,000 20,000 Other Capital 105,000 17,500 17,500 17,500 17,500 17,500 17,500 TOTAL 1,000, , , ,833 52,500 42,500 17,500 Gap Analysis GAP (75,833) (85,833) (120,833) 167,500 52,500 62,500 CUMUL GAP (75,833) (161,667) (282,500) (115,000) (62,500) (0) CUMUL GAP / TA -7.58% % % % -6.25% 0.00% 52

54 Liability Sensitive Financial Institution Issue: The client is liability sensitive, and concerned about a rising rate environment is on the horizon Bank would prefer to maintain a more neutral or less liability sensitive A/L Gap position Expected Transaction: Bank enters into a swap that synthetically converts the Trust Preferred facility to fixed rate Bank Pays Fixed Bank Receives Floating Solution: Bank identifies Trust Preferred facility as instrument to be hedged. Characteristics are as follows: Bank Fixed Rate 3MoL 3MoL + Spread Counterparty $20 Million Maturity MoL + Spread Pricing: 3 Mo. Libor Bps Bank Determines Appropriate Swap Structure Trust Preferred 53

55 Price Determination Issue: Bank wishes to swap the interest rate on a Trust Preferred structure to a fixed rate for 5 years Bank Fixed Rate 3MoL Counterparty Determine the appropriate term of the hedge Bank would like to lock in a rate for the next 5 years 3MoL + Spread Determine the corresponding swap transaction. Currently, the market indicates that the 5 year swap rate (based on 3 Mo. Libor) is 2.75% Trust Preferred Replace the 5 year swap rate for Libor in the equation to determine the corresponding fixed rate 3 Mo. Libor 2.75% + 200Bps = 4.75% FIXED RATE Result: Bank converts its $20mm Trust Preferred that is currently floating at 3-Month LIBOR Bps to a Synthetic rate of 4.75% fixed Swap Transaction Profile Maturity Fixed Notional Floating Rate date Rate 5 Years $20,000, % 3 Mo. Libor 54

56 Gap Results The Result By swapping the TruPS to 5 year fixed, the institution becomes less liability sensitive LIABILITY SENSITIVE INSTITUTION $ in 000's Detail regarding Repricing TOTAL Reprice Window 0-1 YEAR 1-2 YEAR 2-3 YEAR 3-4 YEAR 4-5 YEAR 5+ YEAR Due From/FF Sold 50,000 50,000 Investments 225,000 75,000 40,000 35,000 40,000 20,000 15,000 Loans 700, , , , ,000 75,000 65,000 Other 25,000 25,000 TOTAL 1,000, , , , ,000 95,000 80,000 Non-Mat Deposits 550, , , ,333 Fed Funds Purch 25,000 25,000 CD 300, ,000 65,000 70,000 35,000 25,000 Capital from TruPS 20,000 20,000 Other Capital 105,000 17,500 17,500 17,500 17,500 17,500 17,500 TOTAL 1,000, , , ,833 52,500 42,500 37,500 Gap Analysis GAP (55,833) (85,833) (120,833) 167,500 52,500 42,500 CUMUL GAP (55,833) (141,667) (262,500) (95,000) (42,500) (0) CUMUL GAP / TA -5.58% % % -9.50% -4.25% 0.00% 55

57 Current Derivative / Option-Based Ideas for Asset Sensitive Financial Institutions 56

58 Asset Sensitive Financial Institution The ASSET SENSITIVE INSTITUTION The client is asset sensitive, and concerned that a stagnant, or declining rate environment will remain for some time ASSET SENSITIVE INSTITUTION $ in 000's Detail regarding Repricing TOTAL Reprice Window 0-1 YEAR 1-2 YEAR 2-3 YEAR 3-4 YEAR 4-5 YEAR 5+ YEAR Due From/FF Sold 50,000 50,000 Investments 225,000 75,000 40,000 35,000 40,000 20,000 15,000 Loans 700, , , ,000 80,000 75,000 15,000 Other 25,000 25,000 TOTAL 1,000, , , , ,000 95,000 30,000 Non-Mat Deposits 550, , , ,333 Fed Funds Purch 25,000 25,000 CD/FHLB 320,000 45,000 35,000 70,000 65, ,000 Capital from TruPS - Other Capital 105,000 17,500 17,500 17,500 17,500 17,500 17,500 TOTAL 1,000, , , ,833 82, ,500 17,500 Gap Analysis GAP 94,167 (25,833) (90,833) 37,500 (27,500) 12,500 CUMUL GAP 94,167 68,333 (22,500) 15,000 (12,500) (0) CUMUL GAP / TA 9.42% 6.83% -2.25% 1.50% -1.25% 0.00% 57

59 Asset Sensitive Financial Institution Issue: The client is asset sensitive, and concerned that a stagnant, or declining rate environment will remain for some time Bank would prefer to maintain a more neutral or less asset sensitive A/L Gap position Expected Transaction: Bank enters into a swap that synthetically converts the FHLB facility to floating rate Bank Receives Fixed Bank Pays Floating Solution: Bank identifies Certain fixed rate FHLB borrowings to be hedged. Characteristics are as follows: Bank 3MoL + Spread Fixed Rate Counterparty $20 Million 5 Years Pricing: 4.05% Fixed Fixed Rate (Alternately: Fixed Rate + Fixed Spread) Bank Determines Appropriate Swap Structure FHLB Borrowing 58

60 Price Determination Issue: Bank wishes to swap the interest rate on a FHLB borrowing to a floating rate Bank 3MoL Fixed Rate Counterparty Determine the appropriate term of the hedge Bank would like to convert to floating for a term of 5 years Fixed Rate FHLB Borrowing (Alternately: Fixed Rate + Fixed Spread) Determine the corresponding swap transaction. Currently, the market indicates that the 5 year swap rate (based on 3 Mo. Libor) is 2.75% 3-Month Libor is currently 2.32% Subtract the 5 year swap rate from the fixed rate to determine the Spread that will be added to the 3 Mo. Libor index New spread to 3-Month Libor = (4.05% %) = 1.30% Result: Bank converts its $20mm FHLB borrowing that is currently fixed at 4.05% to floating at 3-Month LIBOR bps. Swap Transaction Profile Maturity Fixed Notional Floating Rate date Rate 5 Years $20,000, % 3 Mo. Libor 59

61 Gap Results The Result By swapping a specific FHLB facility to Libor-based floating, the institution becomes less asset sensitive ASSET SENSITIVE INSTITUTION $ in 000's Detail regarding Repricing TOTAL Reprice Window 0-1 YEAR 1-2 YEAR 2-3 YEAR 3-4 YEAR 4-5 YEAR 5+ YEAR Due From/FF Sold 50,000 50,000 Investments 225,000 75,000 40,000 35,000 40,000 20,000 15,000 Loans 700, , , ,000 80,000 75,000 15,000 Other 25,000 25,000 TOTAL 1,000, , , , ,000 95,000 30,000 Non-Mat Deposits 550, , , ,333 Fed Funds Purch 25,000 25,000 CD/FHLB 320,000 65,000 35,000 70,000 65,000 85,000 Capital from TruPS - Other Capital 105,000 17,500 17,500 17,500 17,500 17,500 17,500 TOTAL 1,000, , , ,833 82, ,500 17,500 Gap Analysis GAP 74,167 (25,833) (90,833) 37,500 (7,500) 12,500 CUMUL GAP 74,167 48,333 (42,500) (5,000) (12,500) (0) CUMUL GAP / TA 7.42% 4.83% -4.25% -0.50% -1.25% 0.00% 60

62 Current Derivative / Option-Based Ideas to Affect Loans 61

63 Swaps to Affect Loans Scenario: Borrower approaches your bank requesting a fixed rate facility Bank s broader profile dictates a preference for floating rate loans. How do I determine what fixed rate corresponds to our profitability requirements? 1. Price the facility using normal floating rate guidelines 2. Now Through the swaps marketplace determine the corresponding fixed rate 62

64 Swaps to Affect Loans Issue: Bank has an increasing demand for fixed rate loans Borrower requests a $10 million fixed rate loan with a maturity of 5 years Expected Transaction: Bank enters into a swap that synthetically converts the loan facility to a floating rate Bank Pays Fixed Bank Receives Floating Bank would prefer to lend via floating rate Solution: Bank commits to lend via fixed rate Bank Fixed Rate Libor + Spread Counterparty $10 Million 5 Years Pricing: TBD (Through swap pricing analysis) Fixed Rate Bank Determines Appropriate Swap Structure Borrower 63

65 Swaps to Affect Loans Price Determination Issue: Borrower requests a $10 million fixed rate loan with a maturity of 5 years Bank Fixed Rate Libor + Spread Counterparty Per internal pricing metrics, determine the appropriate floating rate spread In this case., 3 Month Libor Bps NOW Fixed Rate Determine the corresponding swap transaction. Currently, the market indicates that the 5 year swap rate (based on 3 Mo. Libor) is 2.75% Borrower Replace the 5 year swap rate for Libor in the equation to determine the corresponding fixed rate 3 Mo. Libor 2.75% + 300Bps = 5.75% FIXED RATE Result: Swap Transaction Profile Maturity Fixed Scenario: Client converts its $10mm loan that is Notional Floating Rate date Rate currently fixed at 5.75% to 3-Month LIBOR Bps 5 Years $10,000, % 3 Mo. Libor 64

66 Session 2 65

67 Loan Pricing Facility Level Models Methodology: Understand and apply the index correlations Utilize Prime Flat as the baseline for standardized fixed rate pricing 1. Utilize the term structure of Swaps to calculate a baseline 2. Now determine the discount or premium spread to achieve goals 66

68 Loan Pricing Facility Level Models Anticipation of a Fed Move 67

69 Loan Pricing Theory Applied IMPORTANT NOTE ON SELECTING THE PROPER SWAP RATE: ** Must Consider AVERAGE LIFE of the Principal ** In Other Words: If a facility is for 5 Years, but utilizes a 5 Year Amortizing Schedule The *Average life = 2.65 Years Therefore, extrapolate the proper Swap Rate: 2 Yr Swap Rate = 2.63% 3 Yr Swap Rate = 2.70% 2.65 Yr Swap Rate (Extrapolated) = Equivalent Prime Flat Fixed Rate = 5.67% --- *Average Life = Weighted Average Time to Maturity of a Series of Cashflows (Principal). Yr 1 Yr 2 Yr 3 Yr 4 Yr 5 TOTAL 2,000 2,000 2,000 2,000 2,000 10,000 68

70 Historical Perspective 1 Years Worth of Volatilities 5 Year Swap Dec 15th th % Mar 13 th % Current 1.83% Nov 4 th % July 8 th % 69

71 Historical Perspective 1 Years Worth of Volatilities Applied to Loan Pricing May 17 th % Loan Price 6.04% 5 Yr Maturity May 29 th, % Loan Price 5.70% July 7 th % Loan Price 5.02% Sep 7 th % Loan Price 4.71% 70

72 Interest Rate Caps 71

73 Interest Rate Cap Mechanics The seller of the Cap makes a payment to the buyer when the short-term benchmark index rate (e.g. LIBOR) exceeds the Cap strike rate. If the index is equal to or below the strike rate of the Cap, there is no payment. If index rate is greater than the cap strike rate, buyer receives a payment from seller, Payment is equal to the rate differential on the contract amount over the number of days in that period. 72

74 Interest Rate Cap Mechanics The upfront premium is determined primarily by the following factors: Contract Notional Amount Theoretical dollar amount to be protected Tenor Term of the insurance contract Strike Rate The index rate that when exceeded, payments are remitted Implied Rate Volatility high volatility = high cost Shape and steepness of the swap curve The steeper the swap curve = The higher future Libor expectations = Higher cost 73

75 Interest Rate Cap Mechanics The cap functions as an interest rate insurance policy. In exchange for a one-time, up-front payment, the counterparty agrees to compensate the purchasing bank for the increment that the Index Rate rises above a chosen level ( the strike rate ). 8.50% 8.00% 7.50% 7.00% 6.50% 6.00% Payment to Cap Buyer 5.50% 5.00% 4.50% Cap Rate Rate Paid Potential Rate Scenario 74

76 A Typical CAP Transaction Sample of Upfront premiums for certain structures Based on $10 Million Notional Pricing as of June 1 st, 2018 For informational Purposes Only 75

77 Caps to Affect Obligations 76

78 Caps to Affect Loans Scenario: Borrower approaches your bank requesting a fixed rate facility Bank s broader profile dictates a preference for floating rate loans. Bank is looking for products to differentiate from the competition. Possible Solution: 1. Offer a floating rate - with a cap or ceiling on the borrower s rate 2. Now Through the caps marketplace Determine the cost of the cap, and how to pass this cost on to the borrower 77

79 Caps to Affect Loans 78

80 Cap Corridor Mechanics A cap corridor structure is a collaboration of two separate and distinct cap transactions. The bank purchases a cap at a strike level close to current rates. The bank simultaneously sells a cap back to the counterparty with a strike rate at a level where the initial cap economics are no longer beneficial. The net result allows for affordable protection for the bank during the initial stages of a rising rate environment. 5.00% 4.50% 4.00% 3.50% Net Cap Economics 3.00% 2.50% 2.00% 1.50% 1.00% Rate Scenario Purchased Cap Strike Sold Cap Strike Facility Purchase Cap Sell Cap NET ECONOMICS 5 Year Term - $10 Million Strike Rate 0.50% 1.25% $485K - 97 bp $255K - 51 bp NET $230K - 46 bp For informational purposes only. 79

81 Swaps / Options - Customization Swap and Options transactions are extremely customizable to fit the needs of the participants Notional Size Amortization Schedules Rate Variables Start Date End Date Early Exit Option to Enter (Swaption) Many Other 80

82 Swaps / Options - Customization Forward Dating Forward-starting swaps to lock in the rate today for a Start Date in the future. A bank may commit to a facility with a closing date in the future, and can structure a swap to hedge the transaction with today s levels. Forward-starting swaps allow banks to take advantage of favorable rates when the market offers them - not just when coming to market. Bank may have a swap currently on the books that matures in one year Bank determines that rates are set to rise prior to the maturity of the legacy swap Bank enters into a Forward Dated swap to continue the hedge - Transaction takes into account today s levels for start in the future - A premium in the form of a higher rate is paid for consideration of the forward date 81

83 Swaps / Options - Customization Blend/Extend A common restructuring technique for existing interest rate swaps is to amend the characteristics through the blend and extend strategy. This encompasses rolling in the present value of an existing trade into the rate and maturity of a new deal. Bank determines that current rates are significantly lower than legacy swap fixed rate Bank rolls the Underwater mark of the current swap into a new transaction with longer maturity - The result is an immediate lower rate (although still out of the money.) 82

84 Documentation 83

85 Documentation The ISDA Doc Set ISDA International Swap Dealers Association In 1984, standardization of the swaps market began when 18 dealers came together to develop Standardized terms for Interest rate swaps. This resulted in the formation of the International Swap Dealers Association (ISDA) in The group created the first addition of the Code of Standard Wording, Assumptions and Provisions for swaps. In 1987, an ISDA Master Agreement was developed which standardized the basic tenets for participating in the swaps market, including: Wording of contracts Setting of rates Calculation of amounts Calculation of Liquidation values 84

86 Documentation 3 Parts to the ISDA Doc Set The ISDA Master Agreement The ISDA Master Agreement is the standardized portion of the document that spells out all of the global rules and variables related to the swaps market Schedules to the Master Agreement The customized portion of the agreement. This section lays out specific terms and conditions of the transaction between the two parties. This may include additional default language, assign-ability clauses, additional cross-collateralization terms, etc. Credit Support Agreement (CSA) A CSA defines the terms and rules under which collateral is posted or transferred between swap counterparties to mitigate the credit risk arising from "in the money" derivative positions. 85

87 Components of the CSA Collateral Variables to the CSA agreement. Independent Amount Used with unilateral CSA agreements - Less applicable with implementation of Dodd / Frank Required to be pledged as long as there are outstanding obligations between the Bank and counterparty Is the additional collateral required above the net derivatives exposure Minimum Transfer Amount Minimum amount for the exchange of collateral When a party s exposure exceeds the sum of the posted collateral, the amount that must be met before a transfer of additional collateral is required When a party s exposure is less than the sum of the posted collateral, the amount that must be met before a return of the collateral is required Threshold Represents an unsecured dollar level of mark-to-market exposure above which collateral must be posted Often dependent on the credit quality of the party and may be set to vary depending upon the credit rating as well as the party s financial health Customer is required to post collateral when the MTM exceeds the threshold amount 86

88 Collateral Scenario A Bank executes a $10mm, 5-year pay-fixed swap: CSA Terms: o Independent Amount: $0 o Threshold Amount: $100,000 o Minimum Transfer Amount: $50,000 Scenario A: Bank s swap is in-the-money by $75,000 Neither party is in-the-money by less than the threshold amount No collateral is required to be posted to you by you or your counterparty. Scenario B: Bank s swap is out of-the-money by $75,000 Bank s negative position does not exceed the Threshold Amount No collateral is required. 87

89 Collateral Scenario - Continued A Bank executes a $10mm, 5-year pay-fixed swap: CSA Terms: o Independent Amount: $0 o Threshold Amount: $100,000 o Minimum Transfer Amount: $50,000 Scenario C: Bank s swap is out-of-the-money by $125,000 Bank s negative position exceeds the Threshold Amount by $25,000 However, it is not enough to trigger the Minimum Transfer Amount. No collateral posted. Scenario D: Bank s swap is out-of-the-money by $250,000 The Bank is required to post $150,000 of collateral This is the negative value in excess of the Threshold Amount. 88

90 Risks 89

91 Risks Associated with Derivative Transactions Like most any earning asset or interest bearing liability, interest-rate swaps encompass a whole new set of risks that must be addressed: Basis Liquidity Settlement / Credit Market / Interest Rate Risk Tax & Accounting Issues Others 90

92 Risks Associated with Derivative Transactions Basis Risk Basis risk is the potential exposure to the difference between the floating rate on the variable rate hedged facility and the floating rate received from the swap counterparty. (i.e. hedging a loan tied to PRIME with a swap tied to 3MO LIBOR.) Correlation - Prime Vs. Libor Basis Risk % /3/2000 7/3/2000 1/3/2001 7/3/2001 1/3/2002 7/3/2002 1/3/2003 7/3/2003 1/3/2004 7/3/2004 1/3/2005 7/3/2005 1/3/2006 7/3/2006 1/3/2007 7/3/2007 1/3/2008 7/3/2008 1/3/2009 7/3/2009 1/3/2010 7/3/2010 1/3/2011 7/3/2011 1/3/2012 7/3/2012 1/3/ Mo Libor Prime 91

93 Risks Associated with Derivative Transactions Liquidity Risk The risk that the short term variable rate funding source will freeze, or no longer be available to the borrower during the term of the contract. Correlation - Prime Vs. Libor Liquidity Risk % /3/2000 7/3/2000 1/3/2001 7/3/2001 1/3/2002 7/3/2002 1/3/2003 7/3/2003 1/3/2004 7/3/2004 1/3/2005 7/3/2005 1/3/2006 7/3/2006 1/3/2007 7/3/2007 1/3/2008 7/3/2008 1/3/2009 7/3/2009 1/3/2010 7/3/2010 1/3/2011 7/3/2011 1/3/2012 7/3/2012 1/3/ Mo Libor Prime 92

94 Risks Associated with Derivative Transactions Settlement / Credit Default Risk The risk that the counterparty fails to make required payments. i.e. See counterparties Lehman Bros, Bear Stearns Enough Said. 93

95 Risks Associated with Derivative Transactions Market / Interest Rate Risk The risk of decline in the market value of the contract arising from adverse movements in interest rates Because actual interest rate movements do not always match expectations, swaps entail interestrate risk. Put simply, a receiver (the counterparty receiving a fixed-rate payment stream) profits if interest rates fall and loses if interest rates rise. Conversely, the payer (the counterparty paying fixed) profits if rates rise and loses if rates fall. 94

96 Risks Associated with Derivative Transactions Tax & Accounting Issues Any person or company entering into a derivatives transaction is strongly encouraged to consult with their tax, legal, and accounting advisors to determine appropriate tax and accounting treatment (reference FAS 133). FAS 133 dictates that all qualifying derivatives (swaps included) be recorded on the balance sheet at fair value. How (and where) changes in values of these swaps are to be recorded depends on their intended use and other technical considerations. 95