Interest Rate Derivatives Trading

1
Interest Rate Derivatives Trading
Fixed Income Trading
Trading
Gábor KomáromiWS 2008/2009
2
Introduction
3
Introduction

• The lecture will provide an understanding of
  Interest Rate Derivatives and related instruments
  and markets and will discuss in depth the trading
  side. Pricing of trades, hedging of risk and
  risk taking as well as general aspects of trading
  in most markets will be covered.

4
Introduction

• Requirements
• Gute Kenntnisse im Bereich der Zinsmathematik
  gute Excel-Kenntnisse.

5
Introduction

• Dates Location
• We, 17.12.2008 0830-1830 Uhr S4 (H46)
• Th, 18.12.2008 0830-1830 Uhr S2 (H46)
• We, 14.01.2008 0900-1030 Uhr S1 (H46) pls conf!
• Evaluation
• Attendance 20
• Paper 40
• Exam 40
• Disclaimer

6
Exam

• Date Location please confirm with Institut
• 90 minutes
• Bring your calculator!

7
Introduction

• Slides will be uploaded today.
• Contactgabor.komaromi_at_wu-wien.ac.at

8
Introduction
Investment Banking

• MA and Strategic Advisory
• Country Coverage Teams
• Industry Coverage Teams
• Media Telecom
• Healthcare Consumer Goods, Capital Goods
• Energy
• Technology
• Financial Sponsors
• Financial Institutions (FIG)
• Global Markets Solutions
• Equity Capital Markets (ECM)
• Debt Capital Markets (DCM)
• Leveraged Corporate Finance (LCF)
• Equity Corporate Finance (ECF)

• Fixed Income Division
• Equities Division

9
Introduction Investment Banking
10
Introduction Where is the Trader?
Client
BANK
Feedback
Order
Fund Manager
Salesperson
Exchange
Idea
Order
Idea
Client Feedback
Execution
Feedback
Idea
Outlines stock behaviour in market
TRADER
Idea
Analyst at Client
Research Analyst
Feedback
Outlines stock recommendation
Idea
What clients are doing
Request for problem solving
Execution
Execution
Execution
Dealer at Client
Sales Trader
Order
GMAG
Order
Trade/settlement details
Settle
Operations at Client
Operations
Trade
11
Introduction Who is trading?

• Do only Investment Banks trade???
• No!
• Everyone does!!!

12
Introduction Trading Types

• Equity Trading
• Credit Trading
• FX Trading
• Commodities Trading
• Emission Trading
• Art Trading
• playing Poker (?)

13
www.msnbc.msn.com (060420_oil_prices_hmed_1p.hmedi
um.jpg)
14
http//www.turnerconstruction.com/connecticut/file
s_connecticut/200320Swiss20Bank20Trading20Floo
r.jpg
15
by Gabor Komaromi
16
Introduction Why Trade?
Bloomberg Magazine
17
(No Transcript)
18
http//www.tradermonthly.com
19
1. Interest Rate Derivatives Markets Instruments
20
1.1 IR Derivatives Market

• HUGE and GROWING
• other sectorsEquity Linked 6.8Commodities 6.4
  CDS 20unallocated 36
• within IRDsSwaps 207FRAs 18Options 37

http//www.bis.org/statistics/derstats.htm
21
1.2 Interest Rate Instruments
22
1.2 Interest Rate Models
Hull White Model
23
1.2 Interest Rate Instruments

• Bonds Repos
• Futures
• Interest Rate Swaps (incl. FRAs)
• OIS
• CMS, Inflation Linked
• Exotics
• Options on the above

24
1.2.1 Bonds

• various types of BondsFixed Rate, Floating Rate
  Notes (FRNs), High Yield, Zero Coupon, Inflation
  Linked, Equity Linked, Asset Backed Securities,
  Subordinated, Perpetual, Municipal, Lottery,
  Eurodollar, Samurai, Yankee, ...http//en.wikiped
  ia.org/wiki/Bond_(finance)
• most interesting for usFixed Rate Government
  Bonds/Notes like US Treasuries andDBRs but also
  OATs and BTPs

25
1.2.1 Bonds - Treasuries
DetailsWhat is Issue Date?What is
Maturity?What is Int.Rate?What is High
Yield?What is Offer Amt.? US Treasuries
QuotationQuoted in fractions! 5-year note price
of 100-11 (sometimes written 100.11) means 100
11.5/32nds 100.359375 5yr OTR Treasuries
building the core of the USD Treasury Swaps
(!) market.
2008-12-09 03Zhttp//www.treasurydirect.gov/RT/RT
Gateway?pageinstitHome
26
1.2.1 Bonds Feb/07 vs Dec/08
27
1.2.1 Bonds - Treasuries

• What we need to know Settlement Maturity Coupo
  n Price
• FormulaYIELD(settlement,maturity,rate,pr,redemp
  tion,frequency,basis)
• RENDITE() bzw KURS()
• Other FormulasDURATION, COUPNCD, ACCRINT,
  ... (check EXCEL help)

28
1.2.1 Bonds - Repos

• Repos (Repurchase agreements) and Reverse Repos
  are important Money Market tools.
• Very similar to a secured loan with the Bond as
  collateral.
• Coupons are passed to the Repo seller (original
  Long) although ownership is technically with the
  cash lender (Repo buyer).
• Often overnight, if longer called Term Repo

29
1.2.2 Futures

• Money Market Futures
• Eurodollars, Euribor, Short Sterling, etc.Fed
  Funds Futures
• Treasury Futures (TU, FV, TY, US) and Schatz,
  Bobl, Bund Futures, JGB

30
1.2.2 Futures - EDs

• Eurodollar Futures traded on the CME
• Underlying deposit for 3m for 1,000,000
• What does the quote 98.20 mean?
• How much is one point (98.20...98.21)?
• 100-98.201.80
• How much interest do you get at maturity?
• Therefore 1bp is worth 25!

31
1.2.2 Futures - EDs

• What does EDU9 stand for?
• FGH JKM NQU VXZ
• HMUZ are most common and should be known!
• Eurodollar futures cease trading on the second
  London bank business day immediately preceding
  the third Wednesday of the contract month
• Final settlement price is based on the British
  Bankers' Association Interest Settlement Rate
  the Libor Fixing.
• E.g. 16th September 2009, 16th December 2009, ...

32
1.2.2 Futures - Resources

• Books LinksJohn C. Hull Options, Futures
  Other DerivativesPaul Wilmott DerivativesGalen
  Burghardt The Eurodollar Futures and Options
  HandbookBurghardt, Belton The Treasury Bond
  Basis
• For contract specifications and other
  resourceswww.cme.com 3m Eurodollar
  Futureswww.cbot.com Treasury and Fed Funds
  Futureswww.eurex.com Bund Future

33
1.2.3 Swaps Why important?

• Important because of
• liquidity
• flexibility
• ease in taking short positions
• has become the benchmark for assets

34
1.2.3 Swaps Structure

• Plain Vanilla Swaps

Swap Rate (FIXED)
BANK
Counterparty

LIBOR

• Bank / Counterparty can be Anyone
• Swap Rate e.g. 5 semi annual, 30/360, mod.
  following, adjusted
• LIBOR e.g. 3mLibor, quarterly, Act/360, mod.
  following, adjusted

35
1.2.3 Swaps - decomposed
100
100 of a 15ypar bond at 5.00
100 of a 15y par FRN paying Libor
100
5
Fixed/Floating Swap
?
36
1.2.3 Swap Spreads

• SWAP BOND
• Cash Flows in the replicating portfolio of a swap
  spread trade
• 1. Get loan from repo desk
• 2. Buy security
• 3. Give collateral to repo desk
• 4. Pay interest on loan (repo)
• 5. Collect Treasury coupon
• 6. Enter into swap fixed vs. floating

U.S. Derivatives Strategy (by Fidelio Tata) U.S.
Fixed Income Derivatives 2007 Outlook RBS
Greenwich Capital
37
1.2.3 Swap Spreads
38
1.2.3 Swap Spreads

• After netting cash flows out we get
• Client receives Libor /- Spread
• Client pays Repo
• Swap Spread Libor - Repo

39
1.2.3 Swaps

• Details do matter
• Day Count Conventions
• Roll Conventions / Non-Business Day rules
• Adjusted or Unadjusted

40
1.2.3 Swaps

• Details do matter
• Day Count Conventions30/360, Act/360, Act/Act
  (ISMA, ISDA, ...)Act/364Brazilian convention
  http//en.wikipedia.org/wiki/Day_count_convention
• Roll Conventions / Non-Business Day
  rulespreceding, following, modified following
• Adjusted or Unadjusted

41
1.3 Yield Curve Construction
42
1.3 Curve Construction

• Swap / Libor Curve Construction
• Three Main Components Stub/Money
  Market Futures Swaps

43
1.4 ... in Practice

• Parties involved Trader Sales Brokers Comput
  ers Middle Office, Back Office, ...

44
1.4 ... in Practice
45
1.4 ... in Practice
46
2. RISK
47
2.1 RISK - INTRODUCTION

• What is risk?
• potential negative impact
• volatility of results
• measures the downside
• ...

48
2.1 RISK - PRINCIPLE

• SUPPLY / DEMAND is in Economics what ... / ... is
  in Finance
• RISK / RETURN
• Everyone has risk limits at least in theory...

49
2.1 RISK - TYPES

• Interest Rate Risk
• FX Risk
• Credit Risk
• Liquidity Risk
• Operational Risk
• Regulatory Risk

50
2.2 RISK MEASURES

• DV01
• Equivalents
• Maximum Loss
• VAR (will be discussed soon)

51
2.2 RISK DV01

• Calculation of DV01
• Bonds
• Futures
• Swaps

52
2.2 RISK DV01 Swaps 1

• DV01 of a spot starting 10y swap in 100m
  76,000
• What notional has a 5y in 50k?
• What about 50k in a 17y swap?

53
2.2 Trade Types

• Types of trades (fixed / floating)
• outright (spot starting)
• forward swaps
• curve trades
• butterflies

54
2.2 RISK DV01 Swaps 2

• Forward Starting Swaps
• 3y1y Swap in 100m
• A 1y Swap starting in 3 years (3y INTO 1y)
• Equ. to 4y Swap 3y Swap (100m each)
• NET Risk is ?
• 100m 1y Swap discounted, roughly 8k

55
2.2 RISK DV01 Swaps 3

• 3y2y versus 6y2y swap in 50k
• Basically a 3s5s6s8s combination
• Lets calculate...

56
2.2 RISK DV01 Swaps 3
57
2.2 RISK DV01 / VAR

• DV01 deficiencies
• VAR

58
2.2 RISK VAR

• VAR combines into one number the predicted
  maximum loss (or worst loss) over a target
  horizon within a given confidence interval.
• Parameters
• Horizon
• Confidence Level

59
2.2 RISK VAR

• VAR(t days) VAR(1d) Sqrt(T)
• VAR(95) VAR(99) 1.645/2.236
• Usually 1d or 10d VAR
• Usually 95 or 99 Confidence

60
2.2 RISK OTHER