SINGLE SIDED SWAP FUTURES

Transcription

1 SINGLE SIDED SWAP FUTURES (PATENT PENDING) A BETTER CONTRACT DESIGN FOR INTEREST RATE SWAP FUTURES By Mike Hyland of Stonewyck Investments LLC V2.0

2 PROBLEM Interest Rate Swap Futures are not as popular as they should be Regulators encourage increased futures use (transparency) End users benefit from futures use (Basel III) Yet open interest for IRS Futures lingers at less than 100,000 contracts at the CME (as compared to 2MM+ for treasury futures) PROBLEM REASON Interest Rate Swap Futures suffer from a lack of spot to futures basis OTC Interest Rate Swaps trade via yield (i.e., 2.10%) Interest Rate Swap Futures trade via price (i.e., /32 nd ) Since quotes are of different units (% vs. $) traders can t intui\vely observe basis

3 SOLUTION Create a methodology to allow for the trading and quo\ng of Interest Rate Swap Futures on a yield basis Intui\ve spot to futures basis improves product popularity (% vs. %) Fungibility allows for ne]ng Hidden benefits for por_olio compression and ra\onalizing previously executed OTC trades SOLUTION INTRODUCING SINGLE SIDED SWAP FUTURES Get back to basics: a fixed bond vs. short a float bond Use like building blocks Recreate economics of any no\onal/fixed rate swap combina\on Three quick and novel changes: Contract defini\ons two contracts instead of one Unit rate on the fixed leg of the swap Trade as a spread no upfront cash or price needed

4 EXISTING SWAP FUTURES CONTRACT Current IRS Futures contracts contain all of the cash flows of the Interest Rate Swap in one contract: SSSF CONTRACT A simple interest rate swap analogy is the combina\on of being long a fixed bond while being short a float bond (or vice-versa). SSSF contracts make use of the same concept by separa\ng the coupon cash flows of those bonds into two separate contracts: SELLER SELLER BUYER BUYER CONTRACT DEFINITION COMPARISONS CURRENT IRS FUTURE SSSF FIXED SSSF FLOAT Rate Payer Seller Seller --- Floa\ng Rate Payer Buyer --- Seller No\onal Amount $100,000 $100,000 $100,000 Floa\ng Rate Op\on USD-LIBOR-BBA --- USD-LIBOR-BBA Designated Maturity 3 Month Month IRS Effec\ve Date 16-Sep Sep Sep-15 Termina\on Date 16-Sep Sep Sep-25 Rate Payment Dates March & Sept 16 March & Sept Floa\ng Rate Payment Dates Mar, Jun, Sep & Dec Mar, Jun, Sep & Dec 16 Business Day(s) NY and London NY and London NY and London Business Day Conven\on Modified Following Modified Following Modified Following CONTRACT DEFINITIONS BUYER SELLER Rate Day Count 30/360 30/ Hence the Single Sided Swap Futures name. Floa\ng Rate Day Count Actual/ Actual/360

5 EXISTING SWAP FUTURES CONTRACT Current IRS Futures contracts lock the fixed rate at some quasi-market round number and require up-front payments that are hard to intui\vely understand: Exis\ng Futures Contract Rate of 2.25% VS. Underlying Swap Rate of 2.17% 8 BPs Leqover SSSF CONTRACT RATE Rather than amempt to mimic a near market swap rate, SSSF contracts use a unit rate: Using a unit rate allows for a SSSF building block approach where Rate of the number of fixed contracts 1.00% traded is equal to the fixed rate of the underlying swap. For example, transac\ng at a yield of 2.17% just takes 2.17 SSSF contracts: Contract SSSF Rate of 1.00% SSSF Rate of 1.00% VS. Underlying Swap Rate of 2.17% UNIT FIXED RATE DON T LIKE DECIMALS? The concept of frac\onal contracts is hard for some to accept. If that is a problem, just make the unit rate something smaller and increase the number of contracts. SSSF Rate of 1.00% (100 BPs) è 2.17 contracts SSSF Rate of 0.01% (1 BP) è 217 contracts

6 TRADE SSSF CONTRACTS AS A SPREAD The key to using SSSF contracts is to simultaneously buy one type of contract while selling the other type of contract via a spread trade. The ra\o of contracts traded reflects the fixed rate of the underlying swap. No up-front amounts are needed to complete the transac\on. TO REPLICATE A RECEIVE FIXED SWAP WITH A 2.17% COUPON AND A $100,000 NOTIONAL ADJUSTING FOR LARGER NOTIONALS Increasing the no\onal is as simple as trading the SSSF contract ra\o in larger size. TO REPLICATE A RECEIVE FIXED SWAP WITH A 2.17% COUPON AND A $1,000,000 NOTIONAL 0.17 Contract SPREAD TRADING 0.17 Contract 1 Contract Contract 1 Contract 2.17 (2.17 contracts of $100K no\onal * 1% coupon per contract = 2.17% coupon on $100K no\onal) 1.00 Contract 1 Contract X 10 = 1 Contract Contract (1.00 contracts of $100K no\onal * 1.00 LIBOR coupon per contract = 1.00 LIBOR coupon on $100K no\onal) 1 Contract 10

7 TRADE #1 OTC: Pay 2.10% fixed vs. LIBOR on $50MM no\onal SSSF Equivalent: Bid 2.10 for X 500 = 1, NETTING Just like all other types of futures contracts, the SSSF contracts would all be fungible and would all net. Floa\ng contracts would net against floa\ng contracts contracts would net against fixed contracts NETTING TRADE #2 OTC: Receive 2.201% fixed vs. LIBOR on $100MM no\onal SSSF Equivalent: Offer 1,000 at X 1,000 = 2,201 1,000 Taking the examples from the leq hand column, here is how the ne]ng would look: SSSF FIXED SSSF FLOAT Trade #1 (1, ) Trade #2 2, (1, ) Trade #3 ( ) Net ( ) TRADE #3 OTC: Pay 2.163% fixed vs. LIBOR on $25.55MM no\onal SSSF Equivalent: Bid for X =

8 EXPIRATION Any SSSF contracts outstanding at expiry can easily be converted into OTC Interest Rate Swaps which would then be cleared by the clearing house. (If physical delivery is not an op\on, contracts could also be semled to cash using the same type of semlement procedures currently used by exis\ng IRS Futures contracts.) EXPIRATION Following along with our ne]ng example on the previous page: Step 3: Determine Cash Flow x x $100,000 No\onal per Contract 1% Payment per Annum $598, per Annum Step 1: Determine Direc\on Counterparty is so Counterparty pays LIBOR Step 2: Determine No\onal x $100,000 No\onal per Contract $24.45MM No\onal Step 4: Determine Coupon $598, per Annum / $24.45MM No\onal = % Carry out to as many decimals as needed to exactly match the cash flow Clearing House LIBOR $24.45MM No\onal % Counterparty

9 VALUATION FOR MARGIN Throughout the life of the SSSF contracts, dollar valua\ons will need to be amached to the contracts for the purposes of margining Swap clearing houses already have wellestablished methodologies for amaching valua\ons to cleared OTC swaps These same methodologies can be easily ported over to the valua\on of outstanding SSSF contracts Consistent valua\on between OTC swaps and SSSF contracts will ensure consistent por_olio mark-to-market values for customers DOLLAR PRICE SPREADING It is an\cipated that more than one set of SSSF contracts will be outstanding at a \me (i.e., a September contract and an December contract) The difference in dollar prices between these different contracts should be rela\vely stable Therefore, these contracts offer amrac\ve opportuni\es for market par\cipants to clean up odd lots by execu\ng spread trades between similar contracts (i.e., SSSFXU vs. SSSFXV or SSSFLU vs. SSSFLV) VALUATIONS Note that the swap rate should be equal to the ra\o of the vs. dollar prices IMPLIED SWAP RATE EXPIRATION MONTH SSSFX FIXED SSSFL FLOAT 2.00% August $9,038 $18, % September $8,978 $18, % October $8,939 $19, % November $8,900 $19,581 Spread trading poten\al (in dollars)

10 EFPs Swap counterpar\es will also be able to par\cipate in SSSF contracts via Exchange for Physical transac\ons. As long as all of the details of the OTC swap match the details of the SSSF contracts (dates, day counts, holidays, etc.), the SSSF contracts will provide the same economics as the OTC swap and offer the benefit of ne]ng with other SSSF trades. Bank 1 Bank 2 Clearing House Bank 1 Bank 2 EXCHANGE FOR PHYSICAL EFP transac\ons could facilitate: newly traded spot start OTC swaps that were executed on the SSSF first reset date old trades where the remaining cash flow dates match the SSSF contract dates

11 CONTRACT LIFECYLCLE Important items to consider in planning SSSF contract calendars: The SSSF contracts should list before the first reset date so it can be used to manage resets The SSSF contracts do not have to expire at the underlying swap s first reset date or start date they should con\nue to trade using a fixed LIBOR for some period of \me aqer the underlying swap start date Allowing the SSSF contracts to trade aqer the underlying swap start date will allow for EFPs of old OTC swaps and any spot start OTC swaps that match up with SSSF contract dates The basis between spot and the lead contract should be kept small (i.e., lead contract should change frequently) Speculators should be able to maintain their posi\ons for a reasonable amount of \me without having to worry about expiry or rolling er contract lead \mes allow for op\ons trading of contracts (i.e., 6M and 1Y expiries) Given the above, a suggested calendar lifecycle is displayed to the right EXAMPLE OF KEY DATES FUTURES CONTRACT Month and year of Contract Name contract expiry 1st day of month, First Trade 11 months prior to expiry Last day of expiry Last Trade month September 2015 Wed, Oct 01, 2014 Wed, Sep 30, 2015 Delivery Last Trade + 2 days Fri, Oct 02, 2015 UNDERLYING SWAP IMM Monday of Swap Reset Date expiry month IMM Wednesday of Swap Start Date expiry month Annual anniversary Swap End Date date of Swap Start Date Quarterly/Semi/ Annual anniversary Swap Roll Dates date of Swap Start Date Mon, Sep 14, 2015 Wed, Sep 16, 2015 Tue, Sep 16, 2025 Mar, Jun, Sep & Dec 16 HAVE 12 CONTRACT EXPIRIES OPEN FOR TRADE AT A TIME SIMILAR TO 1M E$ FUTURES CALENDAR

12 For More Informa\on: Mike Hyland Stonewyck Investments LLC No part of this document may be copied, whether by photographic or any other means, without the prior wrimen consent of Stonewyck Investments LLC.