Lecture 4 2016 ALM

Lecture 4: Swaps in practice
Mark-Jan Boes
February 11, 2016
Faculty of Economics and

Business Administration!
Part I
Introduction
Lecture 4
Mark-Jan Boes

Introduction
If we would live in 2007 right now, we would be pretty much done

with the formal treatment of swaps and the usage of swaps in
hedging interest rate risk.
The fixed income world was considered to be risk free meaning
that the text book world closely resembled reality.
For example, the term structure implied by swap rates was close to
the term structure implied by Bunds, Dutch government bonds or
French government bonds.
We could take a lot of interest rate curves as a proxy for the risk
free interest rate curve.
Lecture 4
Mark-Jan Boes

Introduction
Hence, ABN AMRO Pension Fund could construct the nominal

matching portfolio as follows:
provide the pension fund cash flows to an asset manager
give the swap based discount curve to this manager
ask the manager to replicate the return on the liabilities
the manager enters into a bunch of interest rate swaps and
uses the cash to generate the floating payment of swaps
the portfolio replicates carry, duration, curve positioning and
convexity of the liabilities
So, the end result would be a simple portfolio that tracks the
development of the liabilities very closely.
But then 2008 happened and the world experienced the
consequences of taking credit risk.
Lecture 4
Mark-Jan Boes

Introduction
Counterparty risk enters the problem in different ways:

counterparty credit risk in the interest rate swap contract:
what happens if the counterparty in the swap contract goes
bankrupt?
the floating rate usually is a rate that contains a
compensation for counterparty risk
what about the cash? is it truly risk free?
In the remainder of this lecture well dig further into this issue,
with the focus on interest rate swaps.
Lecture 4
Mark-Jan Boes

Part II
Swap valuation
Lecture 4
Mark-Jan Boes

Derivatives valuation
Three ways to calculate the theoretical value of a derivative:

1
the cost of replication
discounting expected risk-neutral cash-flows with the risk free

rate
discounting expected real-world cash-flows with the pricing

kernel (stochastic discount factor)
For linear instruments, such as swaps, we often use the replication

method.
Lecture 4
Mark-Jan Boes

Swap valuation
For swaps we could also write down the valuation formula a bit
more formally (floating leg paid once per year).
The fixed leg (we assume a notional amount of 1):
" n
#
RT
X R Ti
i
Q
VtFixL = Et B
e t ru du K + e t ru du
i=1
And the floating leg:

VtFloL
EtQB
" n
X
RT
i
t ru du
yTi1 :Ti + e
RT
i
t ru du
i=1
where r represents the short rate, K the swap rate and yTi1 :Ti the
1-year interest rate observed at time Ti1 .
Lecture 4
Mark-Jan Boes

Swap valuation
For a swap in which the fixed rate is received we have the following
value:
"
Vtswap = EtQB
n
X
RT
t
#
i ru du
K EtQB
i=1
" n
X
RT
t
#
i ru du
yTi1 :Ti
i=1
We assume that:

RT
P(t, T ) = EtQB e t ru du
where P(t, T ) is the price of a zero coupon bond.
Lecture 4
Mark-Jan Boes

Swap valuation
We took P(t, T ) from markets and not from an interest rate

model.
So we are left with:
Vtswap =
n
X
P(t, Ti )K
i=1
n
X
P(t, Ti )EtQB yTi1 :Ti
i=1
We can rewrite this expression as:

Vtswap
n
X
h
i
P(t, Ti ) K EtQB yTi1 :Ti
i=1
Lecture 4
Mark-Jan Boes

Swap valuation
Then we use that the risk-neutral expectation of a future interest

rate is the forward rate.
Vtswap
n
X

P(t, Ti ) K ft:Ti1 :Ti
i=1
Hence, take the interest rate curve from the market, calculate
discount factors and pricing follows easily.
In traditional pricing it is not necessary to calculate forward rates,
i.e. the formula above can be rewritten such that the forward rates
disappear.
Lecture 4
Mark-Jan Boes
10

Risks in swaps
The swap story could have ended over here and, in fact, a lot text
books actually do so.
But suppose now that the swap portfolio of ABN AMRO has a
DV01 of EUR 20 million and that interest rates drop with 100bps.
Then the market value of the swaps would have been risen with
approximately EUR 2 billion (ignoring convexity).
Also imagine that all those swaps would have been traded with one
counterparty (Lehman Brothers?!)...
Would you be sleeping during the night?
Lecture 4
Mark-Jan Boes
11

Swap valuation
Implicitly we have made a lot of assumptions in our pricing

approach, among which:
there is no risk that one of the parties in the deal doesnt pay
all inputs are derived from the same curve: the basis for the
discounting curve and the forecasting (future interest rate)
curve is exactly the same
there are no collateral agreements
These assumptions were close to reality before 2008. However,
today we know better than that...
Besides, we havent said anything yet about the floating rate in
swaps.
Lecture 4
Mark-Jan Boes
12

Swap valuation
The biggest risk we have to deal with in practice when using

interest rate swaps is counterparty credit risk. This risks leads to a
number of questions:
suppose the floating rate in the swap is the risk free rate but
the counterparty is not how would that influence the value of
the swap?
suppose you would be able to get rid of all counterparty credit
risk and the floating rate in the swap is the risk free rate, how
would swap pricing look like?
suppose you would be able to get rid of all counterparty credit
risk but the floating rate in the swap contains credit risk, how
would that impact valuation?
Lecture 4
Mark-Jan Boes
13

Swap valuation
Other practical risks that we face are:

liquidity risk: the risk that the liquidity of the swap market is
unpredictable, especially for long term swaps
valuation risk: the risk that because of for instance the
presence of counterparty credit risk or capital requirements,
the exact value of a swap is unknown
Lecture 4
Mark-Jan Boes
14

Part III
Swaps in the new reality
Lecture 4
Mark-Jan Boes
15

Swaps: counterparty credit risk
Marking the swap positions to the market leads to substantial

counterparty credit risk.
If the counterparty in the deal defaults, then you lose actual
market value of the swaps and the swap position.
The second consequence can be nasty as it might be expensive to
buy back the exposure in the market under the typical
circumstance of a bank default.
Lecture 4
Mark-Jan Boes
16

If no measures are taken to mitigate counterparty risk the

traditional valuation formula is simply wrong.
Why? Because in traditional valuation only risk free bonds and risk
free interest rates are used (check Hull, for example) but we just
said that the instrument is not risk free.
Swaps are assumed to be risk free instruments: both parties are
going to make their payments with certainty.
Suppose I would enter into an interest rate swap with a bank, I pay
fixed, the bank is non-defaultable but I am not. Would the bank
let me pay a risk free rate as fixed rate?
No! I would definitely pay a higher rate (or: the bank pays me less
in floating). They are charging me a kind of credit spread.
Lecture 4
Mark-Jan Boes
17

A different, and more fundamental, approach is to determine the

default probability of the defaultable party and apply a formula
that could possibly look like:
Vtswap =
n
X

P(t, Ti ) K Qt ( i) ft:Ti1 :Ti
i=1
where Q( t) is the risk-neutral probability that the

counterparty defaults after time t.
In this specific case the fixed rate payer is not risk free. In the
example of the previous slide, the valuation formula is from the
perspective of the bank.
The bank chooses K such that the value of the total structure is
equal to zero at initiation.
Lecture 4
Mark-Jan Boes
18

In order to mitigate counterparty risk, collateral arrangements can

be put in place.
Collateral management: if the value of the swap is negative for the
counterparty, the counterparty must post the market value of the
swap as collateral to you. If the counterparty defaults you become
the legal owner of the collateral.
Most important details of the collateral agreements are (1) the
frequency of collateral posting and (2) the eligible collateral.
Detailed arrangements are written down in the ISDA / CSA
documentation.
Lecture 4
Mark-Jan Boes
19

A CSA defines the terms or rules under which collateral is posted

or transferred between swap counterparties to mitigate credit risk
arising from in the money derivatives positions.
Source: http://www.isda.org/
Lecture 4
Mark-Jan Boes
20

CSA contain agreements on:

eligible collateral (which currencies, bonds etc.)
interest obligation on posted collateral
thresholds
CSA agreements have consequences for swap valuation.
Lecture 4
Mark-Jan Boes
21

Intuitively, it works as follows.

Consider again the situation in which you have a swap that is
worth 20 million dollars.
Whoever your counterparty is, you would feel more comfortable if
the counterparty would post collateral to you: assets of which you
become legal owner in case the counterparty defaults.
Economic ownership stays with the party that posts collateral,
meaning that the receiver must return the coupons (in case of
bond collateral) or must pay interest (in case of cash collateral).
With this collateral, the asset has been made safer (i.e.
counterparty risk is reduced) and therefore has a higher value.
Lecture 4
Mark-Jan Boes
22

For all derivatives: the more often collateral and the better the
collateral is, the lower the probability a default will hurt you.
If for instance, collateral is exchanged on a daily basis and only
non-defaultable assets are allowed as collateral, there is virtually no
pain in case a counterparty defaults.
In credit language: loss given default is virtually zero.
The original pricing formula can be applied in this case (full and
safe collateralization).
Lecture 4
Mark-Jan Boes
23

Ill come back to the issue of CSA-dependent swap pricing later.

Assume now that we are in a situation of full and safe
collateralization.
You might expect that the zero rates implied by fully collateralized
swap rates and risk free zero rates (e.g. zero rates implied by U.S.
Treasury bonds of German Bunds) would be very close.
In that case we could use the swap implied zero rate for all kind of
pricing exercises.
Lecture 4
Mark-Jan Boes
24

This is what we see in practice as of Jan 26, 2015:
Lecture 4
Mark-Jan Boes
25

How is this possible?
How can it be that three curves derived from instruments that are
virtually risk free, are so different?
Lecture 4
Mark-Jan Boes
26

It has to do with the following figure:

6
6mEuribor
EoniaIndex
Raates(points)
Lecture 4
Mark-Jan Boes
27

It is important to know what is in the picture:

Euribor: a banks stated opinion of the rate that other banks
would charge it for a loan
Eonia: an average of actual transactions
Both are rates on unsecured loans: Eonia is an overnight rate,
Euribor can have a tenor from 1 week up to 1 year.
In Euro swaps, 6-months Euribor is typically used for the floating
rate.
Lecture 4
Mark-Jan Boes
28

The picture clearly indicates that there are periods in which there
is a credit risk component in the Euribor rate, otherwise the
difference between couldnt be so large at some points in time.
I.e., Euribor is not a good representation of the true risk free rate.
But that gives an answer to our earlier question: if in a risk free
interest rate swap one party needs to pay a rate (Euribor) that is
higher than the risk free rate why would she accept to receive the
risk free rate? She would definitely demand a rate that is higher
than the risk free rate.
Hence, the zero rate implied by swap rates is definitely not a good
representation of the risk free zero curve.
Lecture 4
Mark-Jan Boes
29

What to do then? For pricing derivatives we need a risk free curve

for discounting.
We could try to use Overnight-Indexed-Swaps (OIS) although
there is a problem with liquidity on the long end of the curve.
What is an overnight indexed swap?
Very similar to a regular swap but the floating payments are
based on the overnight rate (Fed Funds in the US, Eonia in
Europe, Sonia in the UK)
We can bootstrap the discounting curve from OIS swap rates in a
similar way as from Euribor swap rates.
Lecture 4
Mark-Jan Boes
30

Swaps: Valuation risk
Swap curves as of January 4, 2007
Conclusion: curves are really close.

31
Lecture 4
Mark-Jan Boes

Swap curves as of September 18, 2008
Lecture 4
Mark-Jan Boes
32
Question: what is the risk free rate?

And swap curves as of January 31, 2014
Lecture 4
Mark-Jan Boes
33

A couple of important remarks on this:

The difference between an OIS swap rate and a Euribor swap
rate is not because of the difference in credit risk between
both swaps but because of a difference in credit risk between
the floating basis of the swaps.
The value of Euribor swaps with full collateralization, still the
most liquid type of swaps, depends on two curves: the Euribor
curve for future expected payments and the OIS-curve for
discounting.
Although there are a lot of confusing stories about this issue:
theoretically, you should always use the best proxy for the risk
free rate for discounting and make a proper adjustment in the
expected cash flows for credit risk.
In my opinion, this story has been made far too complicated.
Lecture 4
Mark-Jan Boes
34

Lets go back to the original pricing formula:

Vtswap
n
X

P(t, Ti ) K ft:Ti1 :Ti
i=1
In todays reality (under full and safe collateralization):

the discount factors P(t, i) are zero rates implied by OIS swap
rates
the forward rates are based on zero rates implied by Euribor
swap rates
We cannot apply the relation between zero rates and forward rates
anymore to simplify the valuation of the floating leg.
Lecture 4
Mark-Jan Boes
35

In the new reality it would be better to write the pricing formula as

follows (for Euribor-swaps and under full and safe collateralization):
Vtswap =
n
X
h
i
EURIBOR
P(t, Ti )OIS K ft:T
i1 :Ti
i=1
It is good to note that nowadays we need two different curves to

price an interest rate swap.
And...in contrast to the traditional pricing method we need to
calculate forward rates (from the Euribor-curve) over the full life
time of the swap.
Lecture 4
Mark-Jan Boes
36

The following steps should be taken to calculate the value of a

swap in the new reality:
Take OIS-swap rates from the market
Bootstrap the OIS zero curve; this gives the risk free curve for
discounting
Take Euribor-swap rates from the market
Bootstrap the Euribor zero curve
Determine the Euribor forward curve from the Euribor zero
curve
Calculate present value fixed leg using OIS discounting curve
Determine (risk neutral) cash flow projection floating leg using
Euribor forward curve
Discount (risk neutral) cash flows using OIS discounting curve.
Nowadays, this is market standard for swap pricing.
Lecture 4
Mark-Jan Boes
37

In the new reality an interest rate swap still has zero value at
initiation.
However, both legs of the swap have a value above par, i.e.
assuming a notional amount of 1, both the fixed leg and the
floating leg have a starting value that is greater than 1.
Lecture 4
Mark-Jan Boes
38

Swaps: collateral liquidity risk
While mitigating counterparty risk, collateral agreements increase

liquidity risk due to the fact that you might have to post collateral.
In swap positions there is always some liquidity management
needed because of the regular coupon payments.
However, looking after liquidity on the balance sheet becomes
much more important in case of collateral arrangements.
Lecture 4
Mark-Jan Boes
39

Liquidity risk: an example
Consider the following pension fund:

total assets: 10bln
notional swaps (receive fixed): 4bln
duration swaps: 25 years
BPV swaps: 4bln x 25 / 10000 = 10,000,000
P&L swaps: 0
daily collateral management
eligible collateral: Euro cash
Assume that today interest rates increase with 30 bp. Then the
pension fund must post 10,000,000 x 30 = 300,000,000 Euro cash
as collateral.
This is 3% of total assets!
Lecture 4
Mark-Jan Boes
40

Liquidity problems almost led to bankruptcy of Vestia, a large

Dutch housing corporation.
Vestia had quite a large position in swaps (pay fixed), because they
anticipated a rise in interest rates.
However, interest rates went down considerably.
Hence, the value of their swaps was negative so they had to post a
lot of collateral.
The asset side of the balance sheet didnt have sufficient liquidity
to fulfill the collateral obligations.
Lecture 4
Mark-Jan Boes
41

The Vestia got a lot of media attention. The media wrote about
huge losses on derivatives positions.
In essence, there is nothing wrong with a huge loss on derivatives
positions that are used as hedge. There should be an offsetting
gain elsewhere.
It is even not so wrong to build up a swap position to anticipate on
a rise of future interest rates in case you expect to have to raise
debt in the near future.
However, something went terribly wrong in decision making.
Vestia (or their financial advisors) should have done a proper
stress-test, in order to see if the derivatives position could
potentially lead to liquidity problems.
Lecture 4
Mark-Jan Boes
42

So risk management failed....

But please notice that without any collateral arrangements there
would have been no problem at all with liquidity.
Hence, ironically mitigating counterparty default risk almost led
Vestia into bankruptcy.
Lecture 4
Mark-Jan Boes
43

What could they have done instead if they really wanted to have
the market exposure in swaps?
entering into swaps without collateral arrangements
entering into payer swaptions (options on swaps): because a
premium is paid upfront there are no collateral obligations
I will discuss swaptions next week.
Lecture 4
Mark-Jan Boes
44

Swaps: Liquidity risk
The obvious conclusion is that a proper assessment of liquidity risk

is of utmost importance in case there are any zero-cost derivatives
in the investment portfolio, i.e. not only counterparty credit risk is
important.
In AAPF we conduct a weekly liquidity stress-test: we combine a

shock on foreign exchange, interest rates and equities and
determine the possible liquidity and collateral needs.
Lecture 4
Mark-Jan Boes
45

Counterparty credit risk and collateral arrangements not only

complicate liquidity management.
It also influences valuation.
We have seen that already earlier in this lecture.
If there is a daily exchange of collateral, the collateral is risk free,
and the collateral is in the same currency as the swap, then there
is no doubt about valuation.
In that case we dont need to be concerned about counterparty
default risk and we can value swaps by discounting future expected
cash flows with the OIS-curve.
Lecture 4
Mark-Jan Boes
46

In any other case, swap valuation is very difficult.

The intuition is as follows:
the swap has positive value for you (and hence, negative value
for counterparty)
situation 1: no collateral arrangements are in place
situation 2: only Greek government bonds can be posted as
collateral
situation 3: only German government bonds can be posted as
collateral
In which situation is the swap most valuable?
Thats the easy question. But what is the exact swap value in each
of those situations?
Lecture 4
Mark-Jan Boes
47

Obvious input parameters are:

creditworthiness of the counterparty
expected recovery rate of the counterparty in case of a default
current swap rates compared to contract swap rates
creditworthiness of the Greek government
the lifetime of the contract
Not only today, but over the full lifetime of the swaps.
Hence, simulation is needed in order to find the correct value of
the swap.
Lecture 4
Mark-Jan Boes
48

In papers on this subject the value of a derivative usually is

represented as:
Value = NDV CVA + DVA,
where NDV is the no-default value of the derivative, CVA is the
credit value adjustment and DVA is the debit value adjustment.
CVA reflects the possibility that the counterparty will default and
DVA reflects the possibility that the institution itself will default.
DVA is somewhat controversial because a deterioration of the
institution itself leads to a higher asset value of that same
institution.
Lecture 4
Mark-Jan Boes
49

To provide a little bit more intuition for these concepts, suppose

that AAPF has entered into a interest rate swap with a bank.
Assume that the bank pays fixed and receives floating. Hence, the
bank is short a fixed coupon and long a floating rate bond.
We will look at this situation from the perspective of a bank.
If the credit quality of the pension fund worsens than the floating
rate bond will be worth less for the bank, i.e. the discount rate
increases.
There is no change in the fixed leg expected payments because the
credit quality of the bank does not change. In total the value of
the swap will go down for the bank because the bank is long the
floating rate bond and short the fixed coupon bond.
Lecture 4
Mark-Jan Boes
50

Admitted, the valuation formula on the previous slides looks much

simpler than what we have seen before in this lecture: no
expectations, no risk neutral measures and no default probability.
However, it is just presentation, essentially the approaches are the
same.
A formula for CVA:
CVA = (1 )
m
X
P(0, tj )EE (tj )q(tj1 , tj )
j=1
where (1 ) is the loss given default (how much do we expect to

lose), EE is the exposure at default (which exposure is at risk) and
q represents the default probability of the counterparty.
Lecture 4
Mark-Jan Boes
51

So, where are we talking about? Let us take AAPF as an example:

long duration swap portfolio
P&L swaps EUR 3.3 billion under full, daily and safe
collateralization
P&L swaps EUR 3.1 billion under Euribor valuation
difference is more than 0.9% of total assets
Loosely speaking, you could say that CVA is 200 million in the case
Euribor is a fair representation of the counterpartys credit risk.
DVA will be very small because the swaps are very far
in-the-money and because the pension fund is an institution that
basically cannot go into default.
Lecture 4
Mark-Jan Boes
52

AAPF went through the exercise of moving to ISDA / CSA

agreements with safe collateralization.
What happens then in the example on the previous slide?
Theoretically, the counterpartys value moves from -3.1bln to
-3.3bln for which he wants to be compensated.
Yes, the bank would charge us 200mln Euros.
We had a lot of debates about this because who says that 3.1bln is
the correct value under the old collateral agreement? The bank is
inclined to estimate this value as low as possible because he can
profit from it.
Lecture 4
Mark-Jan Boes
53

Another way of thinking about CVA is:

A bank lends 100 Euros to another bank unsecured for one
year(i.e. without collateral arrangements)
The value of this loan is:
Vt =
100 Q( > 1)
100
=
1+y
1+r
where y is the interest the bank requires on the loan, Q( > 1) is

the risk-neutral probability that the borrowing party defaults not
before the maturity of the loan and r is the risk free interest rate.
Lecture 4
Mark-Jan Boes
54

The bank applies a credit value adjustment to the risk free rate:
the difference between y and r .
However if there are collateral arrangements in place such that the
lending bank is protected against the a default of the borrowing
bank, the default probability shouldnt show up in the valuation
formula.
Hence, in this case a credit value adjustment to the risk free rate is
unnecessary and y equals r .
Lecture 4
Mark-Jan Boes
55

Another issue for valuation: collateral options.

For instance, an ISDA might allow for posting US dollar and Euro
cash. This is safe collateral and therefore no issues with CVA and
DVA.
The party in the transaction that has to post collateral is allowed
to choose the currency which is cheapest-to-deliver.
This option has therefore value for the party that must post
collateral.
Lecture 4
Mark-Jan Boes
56

So, consider a swap that is in-the-money (positive P& L) for party

A and out-of-the-money for party B.
Party B must post collateral to party A.
Due to the collateral option the swap is worth less for party A and
has a less negative value for party B than under OIS-pricing.
To make pricing of swaps transparent: dont provide any
multicurrency options for collateral.
Lecture 4
Mark-Jan Boes
57

What does cheapest-to-deliver mean?

To understand that we will turn to the world of cross-currency
basis swaps.
EURUSD X-cur spread
10
0
30/11/2005 30/11/2006 30/11/2007 29/11/2008 29/11/2009 29/11/2010 29/11/2011 28/11/2012 28/11/2013 28/11/2014
-10
-20
-30
-40
-50
-60
-70
-80
date
Lecture 4
Mark-Jan Boes
58

Schematic overview of cash flows in X-currency basis swap:

100USDatT
100USDatt
USDLibor
PartyA
PartyB
EuroLibor+x
100EURatt
100EURatT
Lecture 4
Mark-Jan Boes
59

So assume now that a counterparty needs to pay you a 100mln

Euros collateral in cash or the USD equivalent.
Assume also that the bank can fund against Euribor.
Finally assume that the rate the bank receives on collateral is
Euribor or USD Libor.
This last assumption is unrealistic but helps me in illustrating the
point.
Lecture 4
Mark-Jan Boes
60

Posting Euro cash:

costs Euribor
generates Euribor
Hence, a balance of 0.
Lecture 4
Mark-Jan Boes
61

Posting USD cash:

costs Euribor (funding)
generates Euribor - 15bp (in X-currency swap)
costs USD Libor (in X-currency swap)
generates USD Libor (on collateral)
Hence, a balance of -15bp.
Lecture 4
Mark-Jan Boes
62

The conclusion therefore is that Euro cash is cheapest to deliver.

Valuation of swap, based on current conditions, should be the
no-default value in this case.
However, banks would attach a smaller value to the swap because
they value the possibility that USD cash becomes cheaper than
EUR cash somewhere during the lifetime of the swap.
Lecture 4
Mark-Jan Boes
63

Consequences
From the previous lecture you would think that building a

matching portfolio that follows the short term movements of the
liabilities is quite simple.
If you would use the swap curve (for liquidity reasons) as basis for
discounting future expected cash flows then you could build a
portfolio of swaps and cash that replicates the carry, (key rate)
duration and convexity of the liabilities.
In a world without credit risk the cash would generate the floating
rate in the swap contract and you wouldnt need to be concerned
about a large market value in swap contracts.
Lecture 4
Mark-Jan Boes
64

Consequences
Credit risk changes everything:

which swap curve do you take as a basis to calculate the
present value of liabilities? If youd use the swap curve with
floating rate 6-months Euribor then in the matching portfolio
credit risk needs to taken in order to replicate the carry
swaps lead to basis risk versus the liabilities because the value
of swaps depends on two curves and the liabilities only on one
curve
do you still like solutions with many swaps? Even in the
presence of full and safe collateralization such a solution gives
large exposures to uncontrollable risks as liquidity risk and
valuation risk
The third bullet explains why we usually see large positions in long
term government bonds in matching portfolios: this provides
diversification across different risks.
Lecture 4
Mark-Jan Boes
65

Consequences
Using many long term bonds in the matching portfolio leads to

tracking risk.
What happens for instance when:
the swap curve moves down
government curves remain unchanged
Well, then:
the value of the liabilities goes up, i.e. positive return on the
liabilities
if the matching portfolio contains many bonds, the movement
of this portfolio will be less positive than the liabilities
consequence: the portfolio generates an underperformance
versus the benchmark with an impact on the funding ratio
Lecture 4
Mark-Jan Boes
66

Consequences
Recall that the instantaneous return on a non-defaultable zero

coupon bond can be expressed as:
1
dPt
= ydt (T t)dy + (T t)2 (dy )2
Pt
2
that has a spread s
A similar formula can be derived for a bond P
versus P:
t
dP
1
= (y + s)dt (T t)d(y + s) + (T t)2 (d(y + s))2
2
Pt
then we get (ignoring
If we would then subtract the P from P
second order term):
t
dPt
dP
= sdt (T t)ds
t
Pt
P
Lecture 4
Mark-Jan Boes
67

Consequences
Hence a spread widening (ds positive) has a negative impact on

relative return.
We see from the formula that the impact of spread movements is
related to the duration of the asset, i.e. long term bonds will give
more tracking risk versus a swap-based benchmark than short term
bonds.
Therefore, a replicating portfolio with many swaps and many short
term physical assets has the lowest spread duration and therefore
lowest tracking risk.
Lecture 4
Mark-Jan Boes
68

Summary
What are the main lessons from this lecture?

valuation of a simple interest rate swap is in practice much
more complicated than shown in text books
even in the case of full collateralization with safe assets in the
same currency as the swap the text book arguments do not
hold: in this case we already need two curves to determine the
swaps fair value
the zero curve implied by OIS swap rates is a fair
representation of the risk free curve
theoretically speaking, this zero curve should always be used
for discounting under the risk neutral measure
while mitigating the one risk, other risks might become more
prominent
unless you will be working for a quant desk, you will probably
never face the issues treated in this lecture again
...and last but not least: never trust banks!
Lecture 4
Mark-Jan Boes
69


Lecture 4 2016 ALM

Uploaded by

Document Information

Original Description:

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Lecture 4 2016 ALM

Uploaded by

Copyright:

Available Formats

Lecture 4: Swaps in practice

February 11, 2016

Faculty of Economics and

Faculty of Economics and

If we would live in 2007 right now, we would be pretty much done

Faculty of Economics and

Hence, ABN AMRO Pension Fund could construct the nominal

Faculty of Economics and

Counterparty risk enters the problem in different ways:

Faculty of Economics and

Faculty of Economics and

Three ways to calculate the theoretical value of a derivative:

the cost of replication

discounting expected risk-neutral cash-flows with the risk free

discounting expected real-world cash-flows with the pricing

For linear instruments, such as swaps, we often use the replication

Faculty of Economics and

And the floating leg:

Faculty of Economics and

Faculty of Economics and

We took P(t, T ) from markets and not from an interest rate

P(t, Ti )EtQB yTi1 :Ti

We can rewrite this expression as:

Faculty of Economics and

Then we use that the risk-neutral expectation of a future interest

Faculty of Economics and

Faculty of Economics and

Implicitly we have made a lot of assumptions in our pricing

Faculty of Economics and

The biggest risk we have to deal with in practice when using

Faculty of Economics and

Other practical risks that we face are:

Faculty of Economics and

Faculty of Economics and

Swaps: counterparty credit risk

Marking the swap positions to the market leads to substantial

Faculty of Economics and

Swaps: counterparty credit risk

If no measures are taken to mitigate counterparty risk the

Faculty of Economics and

Swaps: counterparty credit risk

A different, and more fundamental, approach is to determine the

where Q( t) is the risk-neutral probability that the

Faculty of Economics and

Swaps: counterparty credit risk

In order to mitigate counterparty risk, collateral arrangements can

Faculty of Economics and

Swaps: counterparty credit risk

A CSA defines the terms or rules under which collateral is posted

Faculty of Economics and

Swaps: counterparty credit risk

CSA contain agreements on:

Faculty of Economics and

Swaps: counterparty credit risk

Intuitively, it works as follows.

Faculty of Economics and

Swaps: counterparty credit risk

Faculty of Economics and

Swaps: counterparty credit risk

Ill come back to the issue of CSA-dependent swap pricing later.

Faculty of Economics and

Swaps: counterparty credit risk

This is what we see in practice as of Jan 26, 2015: