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5/14/2014
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Interest Rate Hedging:Unveiling Market Complexities
May 28, 2014
New York Cash Exchange
Amanda Breslin, CFA
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Disclaimer
TRANSACTIONS IN OVER‐THE‐COUNTER DERIVATIVES (OR “SWAPS”) HAVE SIGNIFICANT RISKS, INCLUDING, BUT NOT LIMITED TO, SUBSTANTIAL RISK OF LOSS. YOU SHOULD CONSULT YOUR OWN BUSINESS, LEGAL, TAX AND ACCOUNTING ADVISERS WITH RESPECT TO PROPOSED SWAP TRANSACTION AND YOU SHOULD REFRAIN FROM ENTERING INTO ANY SWAP TRANSACTION UNLESS YOU HAVE FULLY UNDERSTOOD THE TERMS AND RISKS OF THE TRANSACTION, INCLUDING THE EXTENT OF YOUR POTENTIAL RISK OF LOSS. THIS MATERIAL HAS BEEN PREPARED BY A SALES OR TRADING EMPLOYEE OR AGENT OF CHATHAM HEDGING ADVISORS AND COULD BE DEEMED A SOLICITATION FOR ENTERING INTO A DERIVATIVES TRANSACTION. THIS MATERIAL IS NOT A RESEARCH REPORT PREPARED BY CHATHAM HEDGING ADVISORS. IF YOU ARE NOT AN EXPERIENCED USER OF THE DERIVATIVES MARKETS, CAPABLE OF MAKING INDEPENDENT TRADING DECISIONS, THEN YOU SHOULD NOT RELY SOLELY ON THIS COMMUNICATION IN MAKING TRADING DECISIONS.
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The Chatham Difference ‐ independent hedging advisor
Interest Rate Hedging FX Hedging Commodity Hedging Hedge Accounting Advisory Regulatory Advisory Debt & Capital Advisory
Full web‐based platform Financial risk mgt modules Debt management modules Covered by SSAE 16 audit
Serving 1200+ clients annually $2.5 trillion notional transacted 6 Locations globally inU.S., Europe, and Asia
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Current IR Landscape
Common Approachesa. Market approachb. Strategic approach
Unveiling Complexitiesa. Pricing dynamicsb. Documentation and Structuringc. Counterparty considerations
Best Practices:Case Study
Today’s Agenda
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5
0.0%
1.0%
2.0%
3.0%
4.0%
5.0%
6.0%
7.0%
Mar‐04 Mar‐05 Mar‐06 Mar‐07 Mar‐08 Mar‐09 Mar‐10 Mar‐11 Mar‐12 Mar‐13 Mar‐14
USD 5Y LIBOR Swap Rate
3M LIBOR
0.0%
0.5%
1.0%
1.5%
2.0%
2.5%
Mar‐12 Sep‐12 Mar‐13 Sep‐13 Mar‐14
Source: Bloomberg
Current Interest Rate Landscape3M LIBOR and 5‐year swap rates have been volatile and are currently historically low
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0.0%
0.5%
1.0%
1.5%
2.0%
2.5%
3.0%
3.5%
4.0%
1 Yr 2 Yr 3 Yr 4 Yr 5 Yr 7 Yr 9 Yr 10 Yr
2010
2015
2014
2013
Current Interest Rate LandscapeInterest Rate Swap Yield Curves
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Pre-Crisis Post-Crisis
Large pool of market dealers
Abundant Liquidity
Less strict bank regulation
Minimum cost of funds among banks
More concentrated pool of market dealers
Constrained credit capacity
Stringent bank regulation
Higher cost of funds among banks.
Efficient execution costs
Close to zero funding charges
Credit and capital charges were flexible
Documentation and KYC requirements were light
Higher execution costs
Meaningful funding charges
Significant credit and capital charges
LIBOR no longer a good proxy for funding cost
Current Interest Rate Landscape
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0.0%10.0%20.0%30.0%40.0%50.0%60.0%70.0%80.0%90.0%
100.0%
86%
44%
71%
86%
44% 50%
88%
58%
81%
96%
59%
81%
92%
39%55%
85%
35%
82%
89%
36%
85%
94%
32%
94%
89%
48%
75%
Source: The State of Financial Risk Management: Quantitative Benchmark Report – Chatham Financial’s independent study of more than 1,000 US, public companies examining their risk exposures, hedging, and hedge accounting practices.
Current Interest Rate LandscapeInterest Rate Hedging by Industry
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Current IR Landscape
Common Approachesa. Market approachb. Strategic approach
Unveiling Complexitiesa. Pricing dynamicsb. Documentation and Structuringc. Counterparty considerations
Best Practices:Case Study
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‐1%
1%
3%
5%
7%
9%
11%
13%
Mar‐14 Mar‐15 Mar‐16 Mar‐17 Mar‐18 Mar‐19 Mar‐20 Mar‐21
68% Probability
95% Probability
Current Interest Rate EnvironmentCurrent Interest Rate Environment
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95% Probability
‐1%
1%
3%
5%
7%
9%
11%
13%
Mar‐14 Mar‐15 Mar‐16 Mar‐17 Mar‐18 Mar‐19 Mar‐20 Mar‐21
5y Swap
5y Swap 1y Fwd+/‐ 2 SD
Current Interest Rate EnvironmentCurrent Interest Rate Environment
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0.0%
1.0%
2.0%
3.0%
4.0%
5.0%
6.0%
7.0%
8.0%
10yr Treasury Swap spread BBB corp spread
Market ApproachFunding Environment
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‐4.00%
‐2.00%
0.00%
2.00%
4.00%
6.00%
8.00%
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2013
2014
3yr Swap Rates
Bias 1yr Forward Actual Average Bias
Market ApproachForward Curve is an imperfect forecaster
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Current IR Landscape
Common Approachesa. Market approachb. Strategic approach
Unveiling Complexitiesa. Pricing dynamicsb. Documentation and Structuringc. Counterparty considerations
Best Practices:Case Study
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Fixed
Floating
Credit Ratios and Covenant Restrictions
Business profile
Rates & Volatility
Capital Structure
Peer ComparisonRates and Volatility
Strategic ApproachFixed & Floating Mix Considerations
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Maintain/ Improve Ratings
Maintain/ Improve Ratings
Meet Investor Requirements Meet Investor Requirements
Manage Covenants Manage Covenants
Board Risk Appetite Board Risk Appetite
0
1
2
3
4
5
6
7
8
Breach Covenant
1 Std Dev “Cushion”
2 Std Dev “Cushion”
2014 2015
Projected Net Debt / EBITDA
Strategic ApproachFinancial Metrics Restrictions and Risk Appetite
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COMPANY B Yr1 Yr2 Yr3Cash 100 150 50Floating debt 250 250 250Fixed Debt 750 750 750Total Debt 1,000 1,000 1,000Net Debt 900 850 950Fixed Exposure 83% 88% 79%
COMPANY A Yr1 Yr2 Yr3Cash 250 200 200Floating debt 250 250 250Fixed Debt 750 750 750Total Debt 1,000 1,000 1,000Net Debt 750 800 800Fixed Exposure 100% 94% 94%
Strategic ApproachLiability Management and Cash Reserves
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Current IR Landscape
Common Approachesa. Market approachb. Strategic approach
Unveiling Complexitiesa. Pricing dynamicsb. Documentation and Structuringc. Counterparty considerations
Best Practices:Case Study
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Mid‐market Level
Credit Value Adjustment (CVA) Cost
Swap Profit
Execution Cost
Funding Cost
All‐In Swap Level
Transparent
Reasonably
transparent and can be estimated
Not transparent
Pricing DynamicsSwap Rate Components
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Example: 10‐year, 3M LIBOR swap rates using different discounting methods
LIBORdual‐curve stripping
LIBORdual‐curve stripping
LIBORtraditional bootstrapping
LIBORtraditional bootstrapping
OISdual‐curve stripping
OISdual‐curve stripping
Discounting MethodDiscounting Method
3.079%3.079% 3.092%3.092% 3.092%3.092%Mid‐marketMid‐market
Source: Bloomberg and Chatham proprietary valuation model. Rates as of March 20, 2014.
(1.3 bps)(1.3 bps) marketmarket marketmarketEarly TerminationEarly Termination
3.100% 3.100% 3.100%
Pricing DynamicsOIS Discounting
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0.0%
1.0%
2.0%
3.0%
4.0%
5.0%
Mar‐14 Sep‐14 Mar‐15 Sep‐15 Mar‐16 Sep‐16 Mar‐17 Sep‐17 Mar‐18 Sep‐18
Swap Rate
0.0%
1.0%
2.0%
3.0%
4.0%
5.0%
Mar‐14 Sep‐14 Mar‐15 Sep‐15 Mar‐16 Sep‐16 Mar‐17 Sep‐17 Mar‐18 Sep‐18
Offsetting Cash Flow Net Cash Flow Paid Net Cashflow Received
Swap Rate
Floor
Example: Vanilla 5‐year swap rate is 1.81%5‐year swap rate with embedded 1% floor: 2.09%
Example: Vanilla 5‐year swap rate is 1.81%5‐year swap rate with embedded 1% floor: 2.09%
Pricing DynamicsEmbedded Floors
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‐$12,000,000
‐$10,000,000
‐$8,000,000
‐$6,000,000
‐$4,000,000
‐$2,000,000
$0
$2,000,000
$4,000,000Expected Exposure and Forward MTM
Forward MTM
Expected exposure
‐2 Standard deviations
Pricing DynamicsCredit Exposure of a Swap
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DerivativesDesk
Collateralized Market
Borrow Collateral
Pricing DynamicsFunding Value Adjustment (FVA)
End‐User
Dealer Bank
UncollateralizedTrade
Collateralized Hedge
Funding Desk
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Current IR Landscape
Common Approachesa. Market approachb. Strategic approach
Unveiling Complexitiesa. Pricing dynamicsb. Documentation and Structuringc. Counterparty considerations
Best Practices:Case Study
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Affiliate Transfers
Novation Rights
Events of Default Provisions
Valuation Disputes
MTM Reset Triggers
Credit Breaks
Mutual Breaks
Ability to Deliver Multiple Currencies
in Collateral
Embedding Options
ACCOUNTING
Step‐up Swaps
Index Choice
Documentation and Structuring Complexities
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vs.
Cancellable Swap
Deferred Premium
Cap
Annuitized Premium
Cap
Swap w/ Embedded
Floor
Step‐Up Swap
Swaption
Swap
Collar
Cap
Documentation and Structuring ComplexitiesProduct Choice
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Current IR Landscape
Common Approachesa. Market approachb. Strategic approach
Unveiling Complexitiesa. Pricing dynamicsb. Documentation and Structuringc. Counterparty considerations
Best Practices:Case Study
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Banks 2008 Current
Morgan Stanley Aa3 Baa2
Bank of America Aa1 Baa2
Citibank Aa3 Baa2
Deutsche Bank Aa1 A2
Societe Generale Aa2 A2
Royal Bank of Scotland Aa2 Baa2
Unicredit Aa3 Baa2
Barclays A1 A3
BBVA Aa1 Baa2
Counterparty ConsiderationsBank Senior Unsecured Credit Ratings
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60+ HOURSto get set up for clearing…
or Policy, Board Review, Resolutions
60+ HOURSto get set up for clearing…
or Policy, Board Review, Resolutions
Constant EvolutionConstant Evolution
40+QUESTIONS
per trading entity in pre‐trade documentation
40+QUESTIONS
per trading entity in pre‐trade documentation
Increased Documentation & Operational Complexity
Regulatory ClassificationsHedging Entity
Counterparties
Product Choice
Regulatory ClassificationsHedging Entity
Counterparties
Product Choice
You decide to hedge
End‐User Exception
ISDA Schedules & CSAs
Portfolio Reconciliation & Reporting
FCM & Give‐Up Documentation
Dodd‐Frank & EMIR Protocols
Reporting & RecordkeepingReporting &
Recordkeeping
Collateral ManagementCollateral
Management
Daily ValuationsDaily ValuationsCompliance Measures
Clearing/End‐User Exception
Portfolio Reconciliation
Reporting
Compliance Measures
Clearing/End‐User Exception
Portfolio Reconciliation
Reporting
Reporting & Recordkeeping
Counterparty ConsiderationsRegulatory Complexities
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Current IR Landscape
Common Approachesa. Market approachb. Strategic approach
Unveiling Complexitiesa. Pricing dynamicsb. Documentation and Structuringc. Counterparty considerations
Best Practices:Case Study
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DOLLARSAVINGS
RISKREDUCTION
60%
PROBLEM:A publicly traded natural gas distributor was evaluating a substantial bond issuance and capital restructure. They wanted to lock in current rates, but anticipated a 6 month delay for the new issuance. They were very sensitive to accounting treatment for any hedges, as they would be crossing a year end reporting period.
SOLUTION:The company identified risk tolerance objectives and set constraints around their hedging program. We were able to evaluate products and counterparties under these constraints and line up efficient execution of their program.
HOW?Our Role
BANKCOUNTERPARTIES
15 Banking Relationships8 ISDAs Negotiated4 Counterparties
1 Rate
Quantification of RiskProduct Choice
Hedge Accounting Execute Transactions
Case Study
Hedge RatioMaintain Flexibility
>$1M
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Questions?www.ChathamFinancial.com
Amanda Breslin, CFA
Director
T: 720.221.3502
Kennett Square235 Whitehorse LaneKennett Square, PA 19348610.925.3120
Denver10026 West San Juan Way, Ste 150Littleton, CO 80127United States720.221.3500
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