Pension Solutions Insights Swaptions: A better way to express a short duration view Aaron Meder, FSA, CFA, EA Head of Pension Solutions Andrew Carter Pension Solutions Strategist Legal & General Investment Management America 8755 West Higgins Road, Suite 600 Chicago, IL 60631
Executive Summary Many pension plan sponsors have a view that interest rates will rise and express this view by having a duration of assets significantly shorter than the duration of liabilities. If interest rates do rise then many of these pension plan sponsors will likely happily add more long duration assets to the plan in order to reduce the duration mismatch between assets and liabilities. It is our view that for plan sponsors who are short duration today due to a view on rates but committed to hedging more if and when rates rise, swaptions can be used to more efficiently express this short duration hedge later mindset. First, we find that selling payer swaptions can be used to simply monetize interest rate triggers and/or sell away funded status upside that has little value. If a plan sponsor has conviction that they will add duration when a target level of rates is achieved, selling a payer swaption allows them to collect a premium by committing to do so (if rates do rise beyond the target level) today. If rates do not rise to the target level, then the premium is realized and the plan s funded status is improved (relative to remaining unhedged) and if rates do rise beyond the target level, then the plan sponsor is forced to lengthen the duration of assets which is likely what they would do anyway. Second, we find that plan sponsors can take the premium received by selling payer swaptions to purchase valuable downside protection by buying a lower strike receiver swaption. This is typically done on a zero up-front cost basis by matching the premium of the receiver swaption with that of the payer swaption. We conclude that these so called zero-cost swaption collars are particularly well aligned with the pension risk management objectives of plan sponsors. A plan sponsor can sell away upside that is either of little benefit or associated with rate levels where the plan sponsor will likely hedge regardless in exchange for more highly valued downside protection in case rates actually fall. We believe this is a more efficient way to express a short duration mindset within a pension risk management context. Last, we assess the current pricing of swaptions. We find that swaptions are attractively priced as you can sell away upside today for a significantly higher price than what is needed to purchase a symmetrical amount of downside protection - meaning that it appears to be a favorable time to be executing such swaption strategies. Introduction For pension plan sponsors adopting a Liability Driven Investing (LDI) strategy, the combination of low interest rates and low funding ratios continues to impede the amount of interest rate risk plan sponsors decide to hedge within their pension plans. Strategically, most LDI adopters acknowledge the benefits of hedging a large proportion of their interest rate risk (our views on the appropriate amount were discussed in our previous white paper - Level 2 LDI: Three key implementation considerations ). As a result, most sponsors have at least extended the duration of the fixed income portfolio in order to hedge a portion of the plan s interest rate risk. However, they choose to be tactically short duration (typically by a wide margin) relative to their optimal strategic interest rate hedge ratio in light of the current low interest rate and funding ratio environment. This amounts to a (typically very large) bet that interest rates will rise causing an improvement in funded status as the present value of liabilities decreases in value more than the assets do. While we can certainly understand today s desire to be short of the strategic interest rate hedge ratio, we encourage our clients to consider (and have seen both US and UK LDI clients increasingly implement) option-based strategies to express this view on interest rates in a more risk controlled manner. Our view is that swaptions, and in particular zerocost swaption collars, are a more efficient means for pension plans to express this interest rate view as opposed to being outright short duration versus the long-term strategic level of interest rate hedging. As will be discussed in more detail later, this is particularly true based on the current market pricing of these types of swaption strategies. Understanding Swaptions Before we discuss the mechanics of swaptions and potential applications to managing interest rate risk, we need to clarify how we are defining interest rate risk. The biggest year-toyear liability risk plan sponsors face is the pension discount rate falling, causing an increase in the present value of the pension liabilities. Importantly, pension discount rate risk can be caused by two different market scenarios (1) Treasury rates falling and/or (2) A-AAA credit spreads narrowing. We refer to the former as interest rate risk and the latter as credit spread risk. Each of these risks needs to be explicitly managed and our focus in this paper is how swaptions can be used to manage the interest rate risk component as opposed to the credit spread risk component of overall discount rate risk. Conceptually, a swaption can be thought of as an option on the value of a bond. Given that the value of liabilities behave similarly to the value of long duration bonds, swaptions can be thought of as an option on the value of pension liabilities. Within this liability risk management context, swaptions can be purchased to provide some protection against increases in the value of the liabilities if interest rates were to fall and/or swaptions can be sold to forgo some of the upside attributable to the value of liabilities falling if interest rates were to rise. Taking this one step further, when working with pension clients to manage funding ratio outcomes, we typically see swaptions being used in two ways (often in combination with one another). First, to provide protection against funded status drawdowns by increasing interest rate hedging (gaining exposure to liability matching bonds) if interest rates fall below a certain level - this can be achieved by buying a 1
low strike receiver swaption. Second, sell away funded status upside attributable to rising interest rates beyond a certain level and/or lock in interest rates at more attractive levels - this can be done by selling a high strike payer swaption. Below we provide an example for each in turn. Buy Receiver Swaption buying protection against falling rates As can be seen below in Figure 2, where a payer swaption is sold, a positive premium is received up front. Losses occur as interest rates rise beyond the strike rate on the payer swaption. However, these losses should be offset by liability gains as the present value of the liabilities falls in this rising rate scenario. Figure 2: Payoff at maturity of a sold payer swaption Technically speaking, the buyer of a receiver swaption has the right, but not the obligation to enter into a receive fixed, pay floating (LIBOR) par swap of a specified maturity (e.g. 30 year par swap) on a specified date in the future at a specified fixed rate 1. Buying a low strike receiver swaption is analogous to buying protection against falling interest rates and the resultant increase in the value of liabilities. Figure 1: Payoff at maturity of a bought receiver swaption 50% Bought receiver swaption payoff at swaption maturity 50% 30% Payoff from swaption 10% 0% 25% 50% 75% 100% -10% -30% Sold payer swaption payoff at swaption maturity Agreed fixed rate (strike rate) Premium received Current interest rate 30% Payoff from swaption 10% 0% 25% 50% 75% 100% Premium 125% -10% paid -30% -50% Agreed fixed rate (strike rate) Current interest rate As can be seen above in Figure 1, if a plan were to buy a receiver swaption the maximum loss is the initial premium which is paid to buy the swaption. From a broader funded status risk management perspective, this strategy could be considered to be very similar to buying a put option on the plan s equities. That is, we have purchased the right to buy bonds (i.e. increase the interest rate hedge) to offset the increase in liability value as interest rates fall beyond an agreed level. The payoff from the receiver swaption will be similar to that of the incremental increase in liabilities if interest rates fall below a certain level (the strike of the swaption). Buying receiver swaptions therefore can be an appropriate risk management strategy for LDI adopters. Sell Payer Swaption selling upside attributable to rising rates Technically speaking, the seller of a payer swaption has the obligation to enter into a receive fixed, pay floating (LIBOR) par swap of a specified maturity (e.g. 30 year par swap) on a specified date in the future at a specified fixed rate. Selling a high strike payer swaption is analogous to selling away some of the benefits attributable to rising interest rates and the resultant decrease in the value of liabilities. -50% From a broader funded status risk management perspective, this could be considered to be similar to a covered call structure (selling a call option) on the plan s equities. That is, we have sold someone the right to sell bonds to us as interest rates rise (i.e. increasing the interest rate hedge) beyond a certain level. This forgoes the funded status gains achieved as the decreases in the value of the liabilities are offset by mark-to-market losses on the payer swaption position if interest rates rise above a certain level (the strike of the swaption). Often times a pension plan will set the strike rate of the swaption to be at a rate where it would likely increase its interest rate hedge ratio anyway. Managing Funded Status Outcomes: A case study As we contended in the introduction, we consistently find that a number of plan sponsors strategically desire a significantly higher interest rate hedge ratio, but are uncomfortable doing this under current market conditions in the belief that interest rates are going up in the future. The most common approach to expressing this view that rates will rise is to simply maintain a significantly lower interest rate hedge ratio compared to the long-term strategic interest rate hedge ratio. Figure 3 shows, for a typical plan sponsor situation (Unhedged), how the funded status of the plan changes with respect to changes in interest rates. We define this typical situation (Unhedged) as a plan which has liabilities of $1 billion, is 90% funded, and has a duration of 13 years. We also assume the plan has 40% of the portfolio in fixed income with duration of 13 years. Finally, as a frame of reference, we also show the impact of changes in interest rates for the same plan sponsor assuming they have fully hedged the interest rate risk (Hedged). 1 In practice, the majority of swaptions are cash settled rather than swap settled, i.e. instead of entering into a swap, the buyer of the swaption receives that mark-to-market value of the swap on the option maturity date were it to have been executed at the specified rate. 2
Surplus / (Deficit) Figure 3: Effect of interest rate changes on funded status outcomes 300 200 100 - (100) (200) Funded Status ($M) Stranded Surplus (300) (400) Significant sponsor obligation Hedged Unhedged (500) -250-200 -150-100 -50 0 50 100 150 200 250 Change in discount rate relative to future expected level (bps) Figure 3 shows that by being outright short duration, the plan sponsor has both a large and asymmetric bet that rates will rise in the future. By large we are referring to the fact that if, for example, rates fell 100 basis points the funded status would deteriorate by $92 million. This is a large risk relative to the size of the plan and, depending on how it s analyzed, it is not unusual for this interest rate risk to be larger than the plan s equity market risk. By asymmetric we are referring to the negative convexity associated with being short duration versus the plan s liabilities. Put simply, the dollar increase in funded status for every 1 basis point (0.01%) increase in interest rates is less than the dollar decreases in funded status for every 1 basis point decrease in interest rates. This can be seen in the chart by the slope of the unhedged position, which is higher at lower levels of interest rates. As an example, based on our sample plan, if rates fall 100 basis points the funded status decreases by $92 million and if rates rise by 100 basis points the funded status increases by $75 million. happy to increase the plan s interest rate hedge ratio. In particular, in our opinion, there is a point (target interest rate) for all sponsors whereby the potential benefit of an improvement in funded status due to increasing interest rates is more than offset by the risk of deterioration in the funded status from a fall in interest rates. In the extreme, for a plan fully funded on a Treasury or annuity buyout basis, it would seem intuitive to hedge all of the interest rate risk, as any potential improvement in the funded status has little benefit to the plan sponsor, with the potential to result in a stranded surplus. This means that the interest rate payoff profile to the plan sponsor is highly asymmetric, in that the plan sponsor is responsible for funding any losses due to falls in interest rates, yet it is unable to fully profit from gains in interest rates beyond a certain level. We therefore contend that the plan sponsor should sell away the exposure from those interest rate scenarios to which it attaches low value. This can be achieved by selling payer swaptions struck at its target rate, which will result in the receipt of a premium, the level of which will depend on how far the plan s target rate is above the market s future expectations for interest rates (a lower target means higher premium). To illustrate this, we continue with our case study and include the impact of selling a payer swaption at a target rate which, if hit, the plan would expect to be fully funded. As can be seen in Figure 4, relative to Unhedged, selling the payer swaption improves the funded status in lower interest rate scenarios due to the swaption premium received, but, relative to Hedged, underperforms as the benefit of the small premium is soon eroded by the increasing value of the liabilities. If rates rise through the strike of the swaption, then this strategy begins to underperform Unhedged, but compared to Hedged, the swaption strategy has significantly outperformed. 300 200 Funded Status ($M) We have found that for plan sponsors with this short duration mindset, there are two ways swaptions can be used to align funded status outcomes with each plan sponsor s objectives. First, is to sell payer swaptions to sell away less valuable upside and/or monetize triggers. Second, is to use a zero-cost swaption collar to more efficiently express this short duration mindset. Note that for this case study, we will use swaptions structures which are based on a sold payer swaption struck at the at-themoney forward ( ATMF ) rate plus 1%, and a bought receiver struck at the ATMF rate minus 1% (for the purposes of the analysis, we assume here that for the collar that these strikes result in a zero-cost structure). The ATMF rate is the market s current expectation of where the swap rate underlying the swaption will be at the expiry date (e.g. for a 2 year into 30 year swaption, the ATMF is the market s current prediction of what the level of the 30 year swap rate will be in 2 years time). Using swaptions to sell upside and/or monetize interest rate triggers We believe, that implicit to the view that rates will rise, there is a level of interest rates at which the plan sponsor would be Surplus / (Deficit) 100 - (100) (200) (300) (400) Hedged Unhedged With Sold Payer Swaption (500) -250-200 -150-100 -50 0 50 100 150 200 250 Change in discount rate relative to future expected level (bps) Figure 4: Effect of interest rate changes on funded status outcomes with sold payer swaption Using swaptions to more efficiently express a short duration view Plan sponsors could simply stop here and use the premium received to boost the funded status in lower interest rate scenarios. We have also seen plan sponsors use this premium to purchase protection on their equity portfolio via out-of-the-money put options or put-spreads (buy a put and sell a lower strike put). However, the most common approach 3
is to use the received premium to purchase a lower strike receiver swaption to protect against significant falls in interest rates below a certain strike level. Working through these key points of customization tends to be an iterative process; however, these decisions are typically addressed in the following order. Surplus / (Deficit) 300 200 100 - (100) Figure 5 below illustrates the impact on funded status of this zero-cost swaption collar strategy under different interest rate scenarios. Figure 5: Effect of interest rate changes on funded status outcomes with collar Funded Status ($M) (200) Hedged Unhedged (300) With Swaption Collar (400) (500) -250-200 -150-100 -50 0 50 100 150 200 Change in discount rate relative to future expected level (bps) As can be seen from the chart, the collared strategy behaves similarly to the Unhedged strategy when interest rates move in the range between the strike of the receiver and the strike of the payer swaption. When interest rates move above the strike of the payer, then the funded status ceases to improve. Similarly, the funded status deteriorates as rates fall to the strike of the receiver swaption, but ceases to fall after the strike is reached. 250 Option maturity: This is the period of time until the option matures. We typically see option maturities between one and three years. There are two primary considerations that are typically balanced when making this decision. Funding target time horizon: Many plan sponsors are significantly underfunded today, and so we often see the option maturity driven somewhat by a realistic time horizon for achieving a particular improvement to the plan s funded status. For example, a plan that is currently 80% funded may be targeting getting back to 90% funded within three years based on assumptions for interest rates, asset returns, and cash contributions over that time horizon. Lengthening the option maturity can allow plan sponsors to target a greater improvement in funded status. Jump risk: While funding considerations may push option maturities out, reducing the option maturity tends to be the best tool to control what we refer to as jump risk. By jump risk we are referring to the scenario where rates spike up through the target rate early on in the option term resulting in the sponsor wanting to enter into a hedge immediately as opposed to waiting for the swaption to expire and then enter into a hedge. The risk is that rates drop after the initial spike and the sponsor may have missed out on an opportunity to hedge at attractive levels. Reducing the option term will decrease the likelihood that a plan sponsor will encounter this scenario. The collar has re-profiled the plan sponsor s exposure to changes in interest rates to be more in-line with its pension risk management objectives. The plan sponsor has sold away upside that is either of little benefit or associated with rate levels where the plan sponsor will likely hedge anyway in exchange for highly valued downside protection in case rates actually fall. We believe this is a more efficient way to express a short duration mindset within a pension risk management context. Customizing a swaption strategy In the previous section, we discussed when it may be appropriate to use swaptions to either monetize triggers (sell payers) or create a collar (sell a payer and buy a receiver). There are four additional points of customization that must also be carefully considered prior to implementation. These are (1) the option term to maturity, (2) the amount of interest rate risk that should be managed with swaptions (3) the strike rate(s), and (4) the maturity of the underlying swap. All of these decisions can be influenced by the prevailing pricing in the market when it comes time to execute the strategy. However, in this section, we address each of these customization points from a strategic perspective and address the implications of the current pricing environment in the following section. Of course, the sponsor could unwind the swaption after the initial spike. However, this brings us to the very important topic of time value which must be carefully considered when implementing option based strategies. By time value we refer to the difference between the actual value of the swaption and the value implied by simply comparing the current swap rate to the strike rate this is the intrinsic value of the swaption. In the scenario where interest rates have spiked higher shortly after implementation, one must keep in mind that the negative mark-to-market of the sold payer at this point would be more negative than the intrinsic value. This can be seen below in Figure 6 as the difference between the line indicating the payoff prior to maturity and the line indicating the payoff at maturity (same as Figure 2). Figure 6: Payoff of a sold payer swaption at and prior to maturity Payoff from swaption 50% 30% 10% Sold payer swaption payoff at and prior to swaption maturity Time value 0% 25% 50% 75% 100% -10% -30% 4-50% Payoff at maturity Payoff prior to maturity
In general, the time value (the shaded area in Figure 6) is directly related to the amount of time until maturity, the volatility of interest rates, and how close current interest rates are to the strike rate. The greater the time until expiry, the greater the volatility of rates, and the closer rates are to the strike, the greater the time value of the swaption. This is because there is a greater chance that there will be an increase (relative to a decrease) in intrinsic value prior to expiry. Therefore, unwinding a sold payer swaption in a scenario where rates spike up shortly after implementation may come at a cost - one that can be reduced by shortening the option term. Amount: Another critical point of customization is around the decision of how much of the interest rate risk to manage with swaptions. As an example, the case study discussed above assumed the plan had hedged a small portion of the interest rate risk through the 40% allocation to long duration bonds and then restructured the full remainder of the interest rate risk through swaptions. However, it is very uncommon for a plan to use swaptions to control risk over the entire amount of remaining interest rate risk. In fact, in our experience we typically see plan sponsors manage no more than 50% of the remaining interest rate risk with swaptions. Some of the key reasons for this are: Strategic hedge is less than 100%: Even if there was not a view from the plan sponsor on rates and funding levels were healthy, there may be good reasons to target a strategic hedge less than 100% of overall interest rate risk (see Level 2 LDI: Three key implementation considerations for details). Basis risk: This refers to the risk that swap rates rise more than the liability discount rate (this is referred to as swap spreads widening) resulting in the mark-to-market losses on the payer swaption offsetting more than the desired amount of decreases in the liability. Reducing the amount of swaptions can mitigate this risk. Jump risk: In addition to shortening the option maturity, reducing the amount of the swaptions decreases this risk. This is because decreasing the amount of interest rate risk controlled with swaptions increases flexibility to, if interest rates subsequently spike higher, hedge the appropriate amount of remaining uncontrolled interest rate risk, without having to unwind the swaption structure. Strike Rate: We have found that there are several factors to consider when setting the strike rates on a swaption strategy and these can vary depending on whether it is a payer or receiver swaption. Payer swaptions: The focus tends to be on the level of interest rates that, if it became available in the market, the pension plan would be happy to hedge more than they are doing today. However, there are two slightly different ways to approach what level of rates this would imply: 1. Funded status approach: This approach focuses on the level of rates that needs to be achieved for the plan to reach its funding target. This level of rates will be highly dependent on assumptions made for asset returns and cash contributions - the higher the asset returns and contributions are assumed to be the lower the level or rates needed to achieve a particular funding target. For plan sponsors that take this approach it is important to consider the risk that, in a rising rate environment, the funding target may not be achieved. This can happen for two market-related reasons, (1) the value of the return-seeking asset component suffers a return shortfall and/or (2) swap spreads widen. This may lead a plan sponsor to push the strike rates up to build in a cushion in case the return-seeking asset portfolio underperforms expectations and/or swap spreads widen. 2. Pure interest rate approach: This approach focuses on the pure level of interest rates where the plan sponsor would no longer hold the view (or have less conviction in the view) that rates are going up. Typically, there is no magic rate that plan sponsors have but rather a more general view that as rates rise they would be willing to hedge more. This may result in having several tranches of payer swaptions at different strike rates (each a bit higher than the last). Receiver swaptions: As these are typically implemented as part of a zero-cost swaption collar, the strike on the receiver is typically solved for by simply taking the premium from the payer swaption and then purchasing a premium equivalent receiver swaption to make the overall structure zero-cost. It is worth noting that this approach will sometimes lead to strikes on the receiver swaptions that are too low to a plan sponsor s liking. In this situation we have seen plan sponsors consider (in addition to considering lower strikes on the payer swaptions) selling a very low strike receiver to collect more premium and therefore purchase a higher strike on the bought receiver while still making the overall structure zero-cost. The trade-off here is that if rates fall below the strike on the sold low strike receiver the plan will be re-exposed to interest rate risk. Maturity of underlying swaps: The maturity of underlying swaps is often tied back to the specifics of the liability profile. The typical approach is to take the liabilities and split the aggregate amount of interest rate risk into various buckets across the curve. This results in understanding how sensitive the liability is to certain parts of the yield curve (i.e. 5 year rates) changing. We then take the existing liability hedging assets and perform the same analytics. Next, for each duration bucket, we take the difference between the liabilities and the liability hedging assets to isolate the interest rate risk remaining in each duration bucket. This output then provides guidance in terms of what proportions the swaptions should be done on 5 year, 10 year, 20 year, and 30 year rates. In summary, there are many things to consider when customizing a swaption strategy. Importantly, these decisions are not independent and one decision may influence another. For example, reducing the option term by one year may give a plan sponsor enough conviction to reduce the strike rate on the sold payer and/or increase the amount of swaptions 5
implemented. As a result, designing an efficient swaption strategy requires balancing all of these key considerations appropriately. Pricing Considerations As with all strategies which meet the objectives of a plan sponsor, it is extremely important to overlay whether the strategy is sensible in light of current market conditions. In fact, we have found that for our clients the pricing of the swaption market at time of implementation has had significant influence over each point of customization discussed above. Further, as pricing changes over the life of the swaption it has a significant influence over when and how it is most appropriate to restructure the strategy. Swaptions, like any other LDI-oriented implementation are not set-it and forget-it strategies. As a means to help explain why pricing is now influential in the management of these strategies, we start by explaining what we mean by the pricing of the swaption market. The main market factors which drive the pricing (premium paid or received) of swaptions are: Moneyness: This is the difference between the strike rate and the current ATMF rate. The ATMF rate is the market s current expectation of where the swap rate underlying the swaption will be at the maturity date. The closer the ATMF rate is to either rising above (in the case of a high strike payer swaption) or falling below (in the case of a low strike receiver swaption) the strike, the higher the premium, and Volatility: This is the expected volatility of interest rates. The higher the expected volatility the higher the premium as large increases in intrinsic value are more likely to occur. Importantly, the expected volatility varies by the strike rate, underlying swap maturity, and option maturity. Therefore, the relative attractiveness of swaption pricing can also vary by these key parameters as well. In our experience, plan sponsors tend to focus on the pricing of zero-cost collars. This can be done tracking the difference in pricing between a sold high strike payer swaption and a bought low strike receiver swaption. An ideal market environment is one where high strike swaptions are priced high (as these are being sold, this maximizes the premium received) and low strike swaptions are priced cheaply (as these are being purchased). This is because pension plans are typically either trying to sell a high strike payer swaption on a standalone basis or combining that with a premium equivalent low strike receiver. The most common way to track the relative pricing between high strike and low strike swaptions is to track what is called the volatility skew. Volatility skew is simply the difference in implied volatility between options on high rates and options on low rates. Figure 7 illustrates volatility skew for 2 year swaptions on 5, 10 and 30 year rates, which is a simple measure of the difference in volatility between the payer and the receiver. Our measure of normalized skew measures the difference in implied volatility of a payer swaption struck at the ATMF rate + 1%, and a receiver swaption struck at the ATMF rate 1%. Figure 7: Historical swaption volatility skew 40 30 20 10 0-10 2 year 5 year 2 year 10 year 2 year 30 year Normalized Skew (ATMF +/- 100bps) -20 Dec 2006 Dec 2007 Dec 2008 Dec 2009 Dec 2010 Dec 2011 Figure 7 also shows that until the end of 2008, the implied volatility of the receiver swaption was higher than that of the payer swaption, meaning in broad terms that the bought receiver was relatively more expensive than the sold payer. However, since the end of 2008 this has reversed, making the bought receiver relatively cheaper than the sold payer. The level of skew peaked towards the end of 2009, but levels still remain elevated, and this is one of the main drivers of why we see an uptick in the amount of swaptions being used by LDI adopters today. In addition, Figure 7 shows that the relative attractiveness of swaptions varies by the tenor of the underlying swap. Current market conditions are that, from a pension funds perspective, swaptions are most attractively priced when they are struck on shorter dated underlying swaps. This is why we have seen, for our LDI clients that have adopted swaptions, a focus on using swaptions on the 5 year and 10 year rates as opposed to 30 year rates. While not shown in Figure 7, this volatility skew can also vary by option maturity and strike rate. For example, for clients who are torn between a 1 year or a 2 year option term or not sure if they should sell a payer 100 basis points or 150 basis points above ATMF rates, the relative volatility skew for these strategies may influence the final decision. In Figure 8 we summarize, for a two year option term, the specific receiver strike rates that could be achieved on a zero-cost swaption collar assuming we sell a payer swaption 100 basis points above the ATMF rate. Figure 8: Swaption strike rates for zero-cost swaption collars (as of 01/04/2012) Sold Bought payer receiver Underlying strike strike Swaption swap relative to Sold relative to Bought tenor maturity Today ' s ATMF rate ATMF payer ATMF receiver (years) (years) rate (%) (%) (bps) strike (%) (bps) strike (%) 2 5 1.28 2.10 +100 3.10-63 1.47 2 10 2.13 2.64 +100 3.64-75 1.89 2 30 2.75 2.91 +100 3.91-91 2.00 We can see in Figure 8 that while the strikes on the payer swaptions are 100 basis points above ATMF rates they are 120-180 basis points above current spot rates. This is 6
because the ATMF rates are significantly higher than current spot rates due the current steep yield curve. As a result of the attractive volatility skew environment, the strikes of the receiver swaptions are closer to the ATMF rates meaning they have less downside than they do upside. Consistent with the above, this is especially true for swaptions struck on shorter dated underlying swaps. Importantly, we should consider the implications of the attractive swaption pricing on funded status outcomes. We do so in Figure 9 where we compare funded status outcomes for a swaption collar strategy where we assume no volatility skew (same as Figure 5) with a swaption collar strategy reflecting the current pricing environment. Figure 9: Effect of interest rate changes on funded status outcomes current pricing We can see that there is identical upside but less downside when reflecting the current swaption pricing a direct result of the attractive volatility skew we just discussed. As previously mentioned, on a strategic basis, we are supportive of using swaptions as a better way to express a short duration view. The current pricing environment simply adds further support to this recommendation. Conclusions For plan sponsors choosing to be tactically short interest rate duration in the anticipation of higher levels of interest rates in the future, we find that swaptions can be an efficient tool in the LDI toolbox. Swaptions can be used to better manage funding ratio outcomes by either monetizing interest rate triggers (by selling payer swaptions) or to more attractively express a short duration view (by implementing a zero-cost swaption collar). Surplus / (Deficit) 200 100 - (100) (200) (300) (400) -250-200 -150-100 -50 0 50 100 150 200 Change in discount rate relative to future expected level (bps) Funded Status ($M) Swaption Collar - Neutral Skew Unhedged Swaption Collar - Current Skew In particular, zero-cost swaption collars are a good fit with the pension risk management objectives of plan sponsors. A plan sponsor can sell away upside that is either of little benefit or associated with rate levels where the plan sponsor will likely hedge anyway in exchange for more highly valued downside protection in case rates actually fall. We believe this is a more efficient way to express a short duration mindset within a pension risk management context. Further, zero-cost swaption collars look attractively priced in a historic context, meaning that it seems a favorable time to be executing such a strategy.. 250 See other Pension Solutions Insights: Managing Pension Liability Credit Spread Risk Managing Pension Liability Credit Spread Risk II: An Update Level 1 LDI: Selecting an appropriate benchmark Level 2 LDI: Three key implementation considerations DISCLAIMER: Views and opinions expressed herein are as of January 2012 and may change based on market and other conditions. The material contained here is confidential and intended for the person to whom it has been delivered and may not be reproduced or distributed. The material is for informational purposes only and is not intended as a solicitation to buy or sell any securities or other financial instrument or to provide any investment advice or service. LGIMA does not guarantee the timeliness, sequence, accuracy or completeness of information included. Past performance should not be taken as an indication of guarantee of future performance and no representation, express or implied, is made regarding future performance. 7