Using Swaptions in an LDI Framework

Teach-In Using Swaptions in an LDI Framework 05 December 2012

Dan Mikulskis (Redington)

Alex Soulsby (F&C)

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The Seven Steps to Full Funding TM


The Fosbury Flop

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Friends Provident 2003 Mexico 1968


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.


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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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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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 37 0

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


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 22 0 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


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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0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

Swap

tio

n D

elt

a as

% o

f Sw

ap D

elt

a

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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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%

Swap

tio

n D

elt

a as

% o

f Sw

ap D

elt

a


The Swaption is very likely to be exercised –

and become a swap

Therefore the delta “behaves like a swap”


Swaptions

Detail delta

Out-Of-The-Money Swaption

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0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

Swap

tio

n D

elt

a as

% o

f Sw

ap D

elt

a


The Swaption is very unlikely to be exercised

– and become a swap

Therefore the delta is close to zero


Swaptions

Detail delta

At-The-Money Swaption

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0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

Swap

tio

n D

elt

a as

% o

f Sw

ap D

elt

a


The probabilities are balanced as to whether

the Swaption will become a swap or not

Therefore the delta is close to 50%


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%

% o

f to

tal l

iab

iliti

es

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%

% o

f to

tal l

iab

iliti

es

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


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


13-15 Mallow Street London EC1Y 8RD Telephone : +44 (0) 20 7250 3331 www.redington.co.uk

Contacts

Dan Mikulskis

Director

ALM & Investment Strategy Direct Line: 020 7250 7107

[email protected]

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Disclaimer

For professional investors only. Not suitable for private

customers.

The information herein was obtained from various

sources. We do not guarantee every aspect of its

accuracy. The information is for your private information

and is for discussion purposes only. A variety of market

factors and assumptions may affect this analysis, and this

analysis does not reflect all possible loss scenarios. There

is no certainty that the parameters and assumptions used

in this analysis can be duplicated with actual trades. Any

historical exchange rates, interest rates or other reference

rates or prices which appear above are not necessarily

indicative of future exchange rates, interest rates, or other

reference rates or prices. Neither the information,

recommendations or opinions expressed herein

constitutes an offer to buy or sell any securities, futures,

options, or investment products on your behalf. Unless

otherwise stated, any pricing information in this message

is indicative only, is subject to change and is not an offer

to transact. Where relevant, the price quoted is exclusive

of tax and delivery costs. Any reference to the terms of

executed transactions should be treated as preliminary

and subject to further due diligence .

Please note, the accurate calculation of the liability profile

used as the basis for implementing any capital markets

transactions is the sole responsibility of the Trustees'

actuarial advisors. Redington Ltd will estimate the

liabilities if required but will not be held responsible for

any loss or damage howsoever sustained as a result of

inaccuracies in that estimation. Additionally, the client

recognizes that Redington Ltd does not owe any party a

duty of care in this respect.

Redington Ltd are investment consultants regulated by

the Financial Services Authority. We do not advise on all

implications of the transactions described herein. This

information is for discussion purposes and prior to

undertaking any trade, you should also discuss with your

professional tax, accounting and / or other relevant

advisers how such particular trade(s) affect you. All

analysis (whether in respect of tax, accounting, law or of

any other nature), should be treated as illustrative only

and not relied upon as accurate.

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EC1Y 8RD

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Using Swaptions in an LDI Framework