For Those About to Swap (We Salute You)

Everyday sensible reasoning using directly observed data leads to an understanding of the true nature of
risks lurking underneath the surface.

Take Aways

 Perverse monetary policies including ZIRP resulted in a radically steep yield curve.
 When policy normalizes and the yield curve flattens, it will lead to significant market dislocations.
 One dislocation will be in the interest rate swap market. Losses could lead to massive swap
unwinds.
 If losses related to unwinds are concentrated in primary dealer positions, this will carry illiquidity
to other asset markets.
 Using the price of money as a control device destroys the information content of prices. Even
marginal introduction of market forces into price formation can lead to crashes.
 When government administered backstops end or fail risk reasserts itself. The most primordial
risk is counterparty risk.
 There is a hedge, and a hedge in enough size becomes a trade.

What it Means to Unwind a Swap

The net present value (NPV) of the swap is the key to any unwind decision. Possible ways to limit IRS
losses are:
1) Enter into a new IRS contract with another counterparty in opposite-ish terms
2) Search the term clauses for a close option in the near future.

Entering an equal but opposite term swap is a way to hedge IRS losses. Basically the swap has to mirror
the original in all aspects, including legal documentation, but be the opposite in terms receiver direction,
e.g. to offset a pay fixed then the contract is to receive fixed. Getting the legal stuff exactly right could be
hard to do, and your accounting system will need to recognize both swaps. If you do enter into a second
swap to hedge the first, the perfect hedge is obtained from an identical offsetting swap. If the original
swap has a non-zero market value, entering into the new swap will entail a cash payment equal to the net
present value of the swap to reflect the new swap's offsetting market value. So you really haven’t helped
yourself much here, unless the IRS is a long duration swap with no close option.

Closing out a swap is what is meant by unwinding a swap. The close option means contacting the original
counterparty to see if the swap terms include a date which gives both parties the right to terminate the
swap with a cash settlement equal to the net present value of the swap.

In short, there is no costless way out of an interest rate swap if you are on the losing leg. If you don’t
want front capital to unwind (close) the swap, then you enter into a new swap with terms that mitigate
the losses. The sheer size of the IRS market implies that the latter is often the chosen option.

Interest Rate Swap Mechanics: Derived NPV

Swap valuation requires:

 Extrapolating a forecast of future interest rates to establish the amount of each future floating
rate cash flow
 Deriving discount factors to value the swap fixed and floating rate cash flow
 Discounting and present valuing all known (fixed) and forecasted (floating) swap cash flows.
These discounting techniques are the same ones used to establish the theoretical market value for any
interest bearing security.
Imagine a notional $100,000,000 swap contract where you pay 6 month LIBOR in exchange for fixed
treasury yield. Below are the quotes you need and the calculations for the present value of that leg. I’m
leaving you details on the mechanics using a few different yield curve scenarios.

Value of Fixed Leg using current data:

Notional Principal: $100,000,000

6-Mo LIBOR at last reset date: 0.00524 (Semi-annual compounding)
Continuously Compounded LIBOR - 3-Mo: 0.0027
Continuously Compounded LIBOR - 9-Mo: 0.00826
Continuously Compounded LIBOR - 15-Mo: 0.01098
Fixed Rate: 0.0384
Valuation:
Risk-Neutral
Expected
Time forward Sem-Ann Frwd term cash flow disct PV
0.25 0.00524 0.00524 0.5 $1,658,000 0.99932523 $1,656,881
0.75 0.01104 0.011070527 0.5 $1,366,474 0.99382415 $1,358,035
1.25 0.01506 0.015116843 0.5 $1,164,158 0.98636876 $1,148,289

Value of Swap: $4,163,205

Given a contract of $100,000,000 with these parameters the summed risk-neutral expected cashflow
present value amounts to around $4.2 million. Fixed receivers are in good shape if longer duration
treasury yields widen and LIBOR stays constant. To illustrate this, I value the swap such that the curve
steepens to an extreme level.

Super-Steep Case:

Notional Principal: $100,000,000

6-Mo LIBOR at last reset date: 0.00524 Semi-annual compounding)
Continuously Compd LIBOR - 3-Mo: 0.0027
Continuously Compd LIBOR - 9-Mo: 0.00826
Continuously Compd LIBOR - 15-Mo: 0.01098
Fixed Rate: 0.045
Valuation:
Risk-Neutral
Expected
Time forward Sem-Ann Frwd term cash flow disct PV
0.25 0.00524 0.00524 0.5 $1,988,000 0.99932523 $1,986,659
0.75 0.01104 0.011070527 0.5 $1,696,474 0.99382415 $1,685,997
1.25 0.01506 0.015116843 0.5 $1,494,158 0.98636876 $1,473,791

Value of Swap: $5,146,446

The Bear Flattener Case:

Notional Principal: $100,000,000

6-Mo LIBOR at last reset date: 0.0261 Semi-annual compounding)
Continuously Compd LIBOR - 3-Mo: 0.0215
Continuously Compd LIBOR - 9-Mo: 0.031
Continuously Compd LIBOR - 15-Mo: 0.0372
Fixed Rate: 0.03
Valuation:
Risk-Neutral
Expected
Time forward Sem-Ann Frwd term cash flow disct PV
0.25 0.0261 0.0261 0.5 $195,000 0.99463942 $193,955
0.75 0.03575 0.036071428 0.5 -$303,571 0.9770182 -$296,595
1.25 0.0465 0.047044776 0.5 -$852,239 0.95456456 -$813,517

Value of Swap: -$916,157

Yield Curve Inversion Case:

Notional Principal: $100,000,000

6-Mo LIBOR at last reset date: 0.0261 Semi-annual compounding)
Continuously Compd LIBOR - 3-Mo: 0.0215
Continuously Compd LIBOR - 9-Mo: 0.031
Continuously Compd LIBOR - 15-Mo: 0.0372
Fixed Rate: 0.015
Valuation:
Risk-Neutral
Expected
Time forward Sem-Ann Frwd term cash flow disct PV
0.25 0.0261 0.0261 0.5 -$555,000 0.99463942 -$552,025
0.75 0.03575 0.036071428 0.5 -$1,053,571 0.9770182 -$1,029,358
1.25 0.0465 0.047044776 0.5 -$1,602,239 0.95456456 -$1,529,440

Value of Swap: -$3,110,824

As yields decline, the fixed leg of the swap loses value. As well, rising float payments are consistent with
losing money on the fixed leg.

IRS Market Developments

Given the size of the market and the leverage involved, the interest rate swap market is a beast too big to
tame. Because of this, major damage could stem from big derivative unwinds if they occur.
Most interest rate swaps are contracted over durations of less than one year. Even so, huge notional
amounts are contracted over the entire yield curve.
$ Millions in Notional
Quarter ending Dec 31, 2009 INT RATE INT RATE INT RATE INT RATE
MATURITY MATURITY MATURITY ALL
< 1 YR 1 - 5 YRS > 5 YRS MATURITIES
TOP 5 COMMERCIAL BANKS $79,924,622 $32,133,361 $25,489,845 $137,547,828
OTHER COMMERCIAL BANKS 1,051,530 1,498,683 653,662 3,203,875
TOTAL COMMERCIAL BANKS 80,976,152 33,632,044 26,143,507 140,751,703
Source: OCC Quarterly Derivatives Report

Trading revenues from these positions turned negative in Q4 2009.

Q1 2009 Q2 2009 Q3 2009 Q4 2009

TRADING REV TRADING REV TRADING REV TRADING REV
TOTAL NOTIONAL FROM INT FROM INT FROM INT FROM INT
INTEREST RATE RATE RATE RATE RATE
DERIVATIVES (Q4 POSITIONS ($ POSITIONS POSITIONS POSITIONS
2009) millions) ($millions) ($millions) ($millions)

TOP 5 COMMERCIAL BANKS $137,547,828 $8,760 $1,691 $4,777 ($1,472)

OTHER COMMERCIAL BANKS 3,203,875 $339 ($583) $675 284
TOTAL COMMERCIAL BANKS 140,751,703 9,099 1,108 5,451 ($1,188)
Source: OCC Quarterly Derivatives Report

Note those trading losses are not year to date; they are for Q4, 2009. $1,472,000,000 is a lot of money to
lose in one quarter. The data presented is insufficient to know with certainty bank IRS positions, but such
a loss profile is consistent with the top five banks paying fixed at durations less than one year. For longer
duration swaps, losses related to yield curve changes could be even more pronounced, as the swap could
initiate before ZIRP began in 2008. In short, manipulation in the New Normal TM (read: zero interest
policies) or its reversal could decimate these positions. Monetary policy normalization and the yield curve
flattening that will come with it could necessitate unwinding.

The situation is not without precedent: reported IRS losses were worse in Q4 2008 (below). Those losses
coincided with a reduction in IRS gross notional amounts, a major increase in counterparty risk (LIBOR-OIS
spread widening) and a radical shift in the term structure. This is just the scenario identified above. The
easily satisfied conditions under which derivative unwinding would contribute to illiquidity and
deleveraging of other assets are:
 unwinding losses are concentrated in prime dealers and
 the amounts unwound are sufficiently large.

Steep losses on IRS could lead to closing of positions again. Due to the sheer size of the market,
unwinding swaps could lead to seriously tight liquidity if settlement cash flows in a concentrated direction
away from prime dealers. This is why long exposure to rising LIBOR-OIS is a good hedge against systemic
meltdown.
A Hedge Position Big Enough Becomes a Trade

The essential hedge against a sizable interest rate swap unwind is intuitive: hedge a bear flattener or
curve inversion. But this same hedge is also a useful hedge against more general systemic meltdowns.
Here’s why.

Markets crash because feasible time horizons of exposure to the market collapse: people want
nanosecond maturity on the yield curve. Such crashes are phase transitions, fast adjustments to new
credible information about reality. Counterparty risk impacts time horizons. The Fed has powerful tools
to impact investment time horizon and they’ve probably used them as never before. However, these
tools are limited in their ability to distort and transfer risk. Everyone has to believe in the Ponzi for the
trick to work. At the epicenter, profiting from rising counterparty risk is a hedge.

The heart of the matter is that the basic foundation of society is exchange. Thus counterparty risk is the
most elemental of all risks. This is why central banks have sunk so much capital into backstops of the
interbank market. For good reason—society is very sensitive to prolonged counterparty risk. As an
example, consider English common law, which is premised on trusting your neighbors more than
government (trial by peers) as opposed to fearing your government less than you fear your neighbors
(court of tribunal). No offense to Code Roman and variations on the appeal to Caesar. Extreme and
sustained counterparty risk ultimately means trust between neighbors breaks down. What remains is a
government that can turn justice into an iron fist.

The rising LIBOR-OIS spread is a clean way to capture the rising counterparty risk embedded in a crisis, as
it is a market sensitive to systemic shocks. One can create a conditional spread trade that replicates a
rising 3 month LIBOR-OIS spread. This is constructed by buying Eurodollar puts and selling OIS puts traded
on CME. Details on these products are here. There are expiration matching issues involved in this hedge.
Building the position is easy to fit into one’s funding limits relative to lending proceeds. You can see
LIBOR-OIS bucking in the 2008 meltdown.
The 3 Month LIBOR-OIS Spread: Another Beast too Big for the State to Tame