Class 15: Interest Rate Swaps

Financial Markets, Spring 2020, SAIF

Jun Pan

Shanghai Advanced Institute of Finance (SAIF)

Shanghai Jiao Tong University

April 10, 2020

Financial Markets, Spring 2020, SAIF Class 15: Interest Rate Swaps Jun Pan 1 / 23
Outline

Global OTC derivatives: notional amounts $640T and gross market value $12.1T.
▶ An important component of the market infrastructure.

▶ The preferred hedging instruments for interest-rate and currency risks.

Interest-rate swaps, notional amounts of $524T.

▶ Reference floating rates: LIBOR and SOFR.

▶ TED spread: 3M LIBOR minus 3M Treasury bill.

▶ Swap spread: swap rate minus Treasury yield of the same maturity.

Mortgage lenders and their interest rate exposures:

▶ The prepayment options by mortgage borrowers.

▶ Negative convexity of MBS.

▶ Hedging interest-rate exposures using interest-rate swaps.

▶ Mortgage lenders in 2020.

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Modern Finance: Theory, Practice, and Lessons

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Global OTC Derivatives

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Derivatives Usage

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Interest Rate Swaps

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Interest-Rate Swap Pricing

Fixed
Floating

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TED Spread: 3M LIBOR - 3M Treasury Bills

LIBOR and TBill Rates (%) TED Spread (bps)

12 500
3M LIBOR
3M TBills
10 400

8 300

6 200

4 100

2 0

0 -100
1990 1995 2000 2005 2010 2015 2020 1990 1995 2000 2005 2010 2015 2020

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TED Spreads in 2008 and 2020

2008 2020
5 2
3M LIBOR 3M LIBOR
4.5 3M TBills 1.8 3M TBills
3M LIBOR - 3M TBills 3M LIBOR - 3M TBills
4 1.6

3.5 1.4

3 1.2

2.5 1

2 0.8

1.5 0.6

1 0.4

0.5 0.2

0 0
Sep 2008 Nov 2008 Jan 2009 Mar 2009 May 2009 Jan Feb Mar Apr May
2020

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LIBOR/IRS and UST Curves

US Treasury Rates (%) LIBOR/Interest-Rate Swap Rates (%)

12 12
3M 3M
2Y 2Y
10 5Y 10 5Y
10Y 10Y
30Y 30Y

8 8

6 6

4 4

2 2

0 0
1990 1995 2000 2005 2010 2015 2020 1990 1995 2000 2005 2010 2015 2020

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Exposure to Counterparty Risk in OTC Derivatives

At inception, swaps have zero dollar value to either parties.

Interest rates fluctuate during the life of a swap:
▶ Swap value turns positive for one counterparty and negative to the other.

▶ The positive-value counterparty now has a credit exposure to his counterparty.

▶ The total sum is always zero.

To limit such counterparty credit risk:

▶ Marked to the market on a monthly/daily basis.

▶ Ask the negative-value counterparty to post collateral (cash or Treasury bonds).

▶ Minimum rating requirements for counterparties.

▶ Weaker counterparties: denied access or tighter collateral requirements.

▶ Tightened collateral requirements in the event of a downgrading.

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Determinants of Swap Spreads

Counterparty risk
Credit risk
▶ The spread of three-month LIBOR (unsecured borrowing) over three-month

general collateral term repo (secured borrowing).

▶ The AA credit spreads

Liquidity convenience yield of treasury bonds

▶ On-off-the-run treasury bond yield differential

Treasury supply
Mortgage backed securities (MBS) and hedging activities

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Swap Spread and Major Events

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Swap Spreads
Swap Spreads (bps) Swap Spreads in 1998 (bps)
250 100
2Y
5Y
200 10Y 90
30Y

150 80

100 70

50 60

0 50

-50 40

-100 30
1990 1995 2000 2005 2010 2015 2020 Aug Sep Oct Nov Dec Jan
1998

Swap Spreads in 2008 (bps) Swap Spreads in 2020 (bps)

200 40
2Y
5Y
10Y 20
150 30Y

100
-20

-40
50

-60

0 2Y
-80 5Y
10Y
30Y
-50 -100
Sep Oct Nov Dec Jan Jan Feb Mar Apr May
2008 2020

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MBS Negative Convexity Hedging

Mortgage borrowers in the US have the option to prepay:

▶ Falling interest rates leads to increased re-financing activities.

▶ With higher probabilities of prepayment, MBS duration shortens.

Convexity: the direction and speed at which duration moves with interest rates.
With falling interest rates:
▶ MBS: shortening duration. Negative convexity.

▶ Treasuries: lengthening duration. Positive convexity.

GSEs (Fannie Mae and Freddie Mac) are the largest buyers of US mortgages:
▶ Their objective: minimize interest-rate exposures by shrinking the duration gap.

▶ Use interest rate swaps and other OTC derivatives (swaptions, floors, caps):

⋆ Falling interest rates: buy duration via adding receive-fixed.

⋆ Increasing interest rates: off load duration via adding pay-fixed.

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Yield and Duration, MBS vs UST

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Risk Management Derivatives, Fannie Mae 2010 10K

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Interest Rate Sensitivity of Net Portfolio, Fannie Mae 2014

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MBS Footprints on Swaps

MBS hedging: 5-10yr IRS.

Sharp increase in 10yr in 2003:
▶ Sudden spike in MBS duration.

▶ Large amount of fixed-payers.

▶ A temporary liquidity spike in

the 10yr swap spread.

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Mortgage Lenders in 2020

Deluged with refinancing demand as rates are sharply lower:

▶ Rate on 30-year fixed-rate mortgage hitting 3.29%, lowest ever recorded.

▶ Refinancing applications rose 224% compared to the year prior.

▶ Refinancing accounts for 75.9% of total mortgage applications.

Facing massive margin calls amid Fed’s QE:

▶ Mortgage banks are losing money on their interest-rate hedges.

▶ Duration hedging: poor performance during volatile markets.

▶ Also exposed:

⋆ Customers failed to close on loans because of quarantines.

⋆ Mortgage lenders stuck with the hedge without the off-setting loans.

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Fed’s QE and MBS in 2020
Bloomberg BarCap MBS Yield (%)
3
QE Announced on 3/15 One Two

MBS: $10.33T as of end 2019.

2.5
Fed announced MBS QE on 3/15.
Week One: 3/19-25
2 ▶ increase in holdings: $1.2B.

▶ decrease in yields: 100+ bps.

1.5 Week Two: 3/26-4/1

▶ increase in holdings: $55.9B.

▶ decrease in yields: 4 bps.

1
3/30
▶ 3/31: one-day spike of 41 bps!
MBS
UST 10Y
0.5
Jan Feb Mar Apr
2020

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Duration Hedging in this Environment = ?

Bloomberg BarCap MBS Yield (%) Bloomberg BarCap MBS Duration

3 4.6
QE Announced on 3/15 One Two
4.4

2.5
4.2

4
2
3.8

3.6
1.5
3.4

3.2
1
3/30
MBS 3
UST 10Y
0.5 2.8
Jan Feb Mar Apr Jan Feb Mar Apr
2020 2020

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Main Takeaways

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