3. Teach-In Using Swaptions in an LDI Framework 05 December 2012
The Fosbury Flop
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Friends Provident 2003Mexico 1968
4. Teach-In Using Swaptions in an LDI Framework 05 December 2012
Swaptions
Objectives of today’s Teach-in
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- To gain a clear sense of why a pension scheme might want to use swaptions.
- To gain a sufficient level of knowledge about the language of swaptions to confidently engage in discussions.
- To have seen examples of specific transactions that have been successfully implemented by pension funds.
- To understand how pension schemes can set themselves up to efficiently implement a swaptions strategy.
5. Teach-In Using Swaptions in an LDI Framework 05 December 2012
Swaptions
The Key Benefits
- Swaptions can be used as an alternative to swaps for hedging some of the interest rate risk of a pension scheme
Under most scenarios you can see better outcomes
- Swaptions can also be used as an alternative to trigger levels, in order to lock into higher yields if yields were to rise
The Scheme therefore collects a premium for agreeing to enter into a swap if yields rise to a certain level
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6. Teach-In Using Swaptions in an LDI Framework 05 December 2012
Swaptions
In detail
A Swaption is an option to enter into a swap
There are two flavours of Swaption :
Payers – an option to enter into a swap paying the fixed leg
Receivers – an option to enter into a swap receiving the fixed leg
In each case there are certain other parameters which apply :
The expiry of the option, this defines at which future point we are able to exercise the option
The term of the swap we are talking about, this need not be the same as the expiry of the option and most of the time will not
be. This can be anything from 1-30 years. For a pension scheme this might typically be 20 or 30 years
The Strike. This is the fixed rate of the swap which we have the option to enter into
The Notional. This is the notional or principal value of the swap contract underlying the Swaption
Other notes
In all cases we are talking about par swaps, as opposed to the zero-coupon swaps we would normally advise clients use for
hedging
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7. Teach-In Using Swaptions in an LDI Framework 05 December 2012
Swaptions
In detail
Example (1)
A pension scheme might buy £100m notional 7y30y receiver Swaption with strike of 2.5%, for a premium of £3.5m This means:
The scheme will pay £3.5m, plus transaction costs (on day 1, the Swaption will be an asset worth £3.5m)
In 7 years from now
The scheme has the right (but not the obligation)
To enter into a 30 year swap on a notional of £100m
Receiving a fixed rate of 2.5%
Clearly in practice it would be profitable to exercise this only if 30yr rates were below 2.5% at the point of expiry in 7 years
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1 2 3 4 5 6 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36
7 370
Time zero: scheme
buys7y30y receiver
Swaption, pays premium
At seven years, scheme has the option to
enter into a fixed rate swap, receiving a
fixed rate of 2.5%p.a. over the next 30
years (and paying LIBOR floating)
If the option was exercised the
scheme then receives fixed and
pays LIBOR floating for the life of
the swap
8. Teach-In Using Swaptions in an LDI Framework 05 December 2012
1 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21
Swaptions
In detail
Example (2)
A pension scheme might sell £75m notional 2y20y payer Swaption with strike of 4% for a premium of £1.4m This means:
The scheme receives premium of £1.4m, less transaction costs (on day 1, the Swaption sits as a liability of £1.4m)
In 2 years from now
The trading counterparty the scheme has sold the option to has the right (but not the obligation)
To enter into a 20 year swap with a notional of £75m with the scheme
Paying a fixed rate of 4% (i.e. the scheme would receive the fixed rate of 4%)
Clearly in practice it would be profitable to exercise this only if 20yr rates were above 4% at the point of expiry in 2 years
Note the difference to the previous example, here the trading counterparty rather than the scheme has the optionality.
That is because we have sold rather than bought an option
In turn we should receive, rather than pay, a premium for this
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2 220
At two years, the
counterparty the
scheme has traded
with has the option to
enter into a swap
paying a fixed rate of
4%
Time zero: scheme sells 2y20y payer
swaption – receives premium
If the option was exercised the
scheme then receives fixed and pays
LIBOR floating for the life of the swap
9. Teach-In Using Swaptions in an LDI Framework 05 December 2012
Swaptions
Detail delta
A position in any option contract, swaptions included, introduces sensitivities to a number of factors, these are known as the
Greeks.
G s r
The most important among these is delta – the sensitivity of the price of the option to a small move in the underlying
A fixed interest rate swap has a delta, more commonly known as the PV01
If rates are shifted by 1 basis point, the PV01 tells us by how much the value of our swap position changes
Swaptions also have a PV01 – and this is why they are useful for scheme hedging purposes
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10. Teach-In Using Swaptions in an LDI Framework 05 December 2012
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
SwaptionDeltaas%ofSwapDelta
Underlying 30 year rate
Swaptions
Receiver Swaption on the 30 year swap rate struck at 2.5%
Intuitive understanding of Swaption delta
For a swap, the PV01 will be relatively constant for small moves in rates
For a Swaption, the PV01 will change as rates change
An intuitive way of thinking of the Swaption PV01 is to relate it to the PV01 of the underlying swap, and think about the probability of exercise
Let us go back to the previous example of a £100m receiver Swaption on the 30 year swap rate struck at 2.5%
Lets say the Swaption is close to expiry now, the PV01 of the 30 year par swap is about £200k
The delta of the Swaption will vary with the underlying rate as follows
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11. Teach-In Using Swaptions in an LDI Framework 05 December 2012
Swaptions
Detail delta
The delta of the Swaption will vary with the underlying rate
In-The-Money Swaption
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0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
SwaptionDeltaas%ofSwapDelta
Underlying 30 year rate
The Swaption is very likely to be exercised –
and become a swap
Therefore the delta “behaves like a swap”
12. Teach-In Using Swaptions in an LDI Framework 05 December 2012
Swaptions
Detail delta
Out-Of-The-Money Swaption
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0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
SwaptionDeltaas%ofSwapDelta
Underlying 30 year rate
The Swaption is very unlikely to be exercised
– and become a swap
Therefore the delta is close to zero
13. Teach-In Using Swaptions in an LDI Framework 05 December 2012
Swaptions
Detail delta
At-The-Money Swaption
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0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
SwaptionDeltaas%ofSwapDelta
Underlying 30 year rate
The probabilities are balanced as to whether
the Swaption will become a swap or not
Therefore the delta is close to 50%
14. Teach-In Using Swaptions in an LDI Framework 05 December 2012
4.0% 1.0%
1.5%
1.7%
16.9%
5.1%
1.5%
1.0%
13.6%
19.0%
0.0%
5.0%
10.0%
15.0%
20.0%
25.0%
30.0%
35.0%
40.0%
%oftotalliabilities
4.0% 1.0%
1.5%
1.7%
20.0%
5.1%
1.5%
12.7%
22.0%
0.0%
5.0%
10.0%
15.0%
20.0%
25.0%
30.0%
35.0%
40.0%
%oftotalliabilities
Swaptions
Evaluating swaptions in an overall risk framework
The overall risk reducing properties of swaptions for a pension scheme can be evaluated in the usual way
Below examples are illustrative – actual impact will depend completely on the size of the Swaption transaction
Swaption will
1. Reduce interest rate risk
2. Introduce small risk to the market price of the Swaption itself (vega risk), which is found to be diversified away – as long as Swaption
position is appropriately sized
The illustration below is for a scheme with the following properties :
• Inflation hedge ratio exceeds interest rate hedge ratio
• Interest rates represent largest single risk factor
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Starting point – no Swaption
With Swaption
15. Teach-In Using Swaptions in an LDI Framework 05 December 2012
Swaptions
Executing Swaptions Requires Efficient Governance
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• Proactive involvement of Investment Manager
• Timely, focused meeting of Investment
Committee
• Constructive discussion from Investment
Consultant
Investment
Committee /
Working Group
Investment
Consultant
Trustee Board
• Set strategic objectives
• Establish risk budget
• Delegate some decision
making ability
LDI Manager
Control Agility & Focus
Transparency
