Home » Posts tagged 'Rates'
Tag Archives: Rates
Matt Levine, Bloomberg, Firm Sues to Stop CFTC From Calling It a Bunch of Cheaters. here.
Eventually, though, IDCH and Nasdaq convinced Jefferies to trade the contract, starting in 2010. This worked because Jefferies did not have a significant incumbent OTC swap business to protect, so it was open to exchange-based trading, and also because Jefferies was dumb and didn’t realize the contract was terrible. It missed the same thing that IDCH and Nasdaq missed, and just believed IDCH and Nasdaq when they said that the futures and swaps were equivalent.
Meanwhile, folks at DRW Investments also started trading the contract, because they were smart and saw that Jefferies were dumb. Basically, Jefferies took one side of a bunch of these contracts (receiving fixed), and DRW took the other on all of them (paying fixed)paid fixed on all of those contracts. The contracts were systematically mispriced: The fixed payer systematically should have paid more than it would under an equivalent swap, but since Jefferies believed that the futures and swaps were identical, it was willing to do the trades at the same rate as an equivalent swap. So DRW obliged (and, one assumes, entered into offsetting swaps, hedging out the interest rate risk and just pocketing the mispricing).
Rama Cont, Radu Paul Mondescu, and Yuhua Yu, SSRN, Central Clearing of Interest Rate Swaps: A Comparison of Offerings, here.
Abstract:Regulatory changes have motivated the development of a variety of solutions for the clearing of interest rate swaps. Margin payments associated with clearing lead to modifications in cash flows which result in differences in the valuation between cleared and non-cleared swaps. We propose a framework for computing these differences and show that they lead to two types of modifications in contract value: a convexity effect and a “Net Present Value” (NPV) effect, which can be significant for long-dated swaps. As a result, modifications in contract design are required in order for a centrally cleared interest rate swap to be economically equivalent to its uncleared counterpart. Among the currently available offerings for cleared interest rate swaps, three offerings are shown to be economically equivalent to their uncleared counterparts – the “Price Alignment Interest” method used by LCH. Clearnet and CME, as well as a new adjustment method used by the Eris Exchange – while a fourth method, used in the IDCG swap futures contract, is shown to lead to substantial deviations in valuation with respect to a non-cleared interest rate swap. Using a Hull-White model calibrated to the market data as of December 2010, we find the difference between the IDCG futures swap rate and the corresponding uncleared swap rate to be around 18 basis points for a 10 year contract and about 60 basis points for a 30 year contract. An interest rate environment with higher volatility will result in larger differences.
The Jefferies Group shows that fixed income isn’t necessarily for everyone. The revenue that the investment bank generated from trading bonds, currencies and commodities slumped 85 percent, to just $33 million, in the three months to September. That’s a far bigger drop than its larger rivals across Wall Street are expecting. As a relative newcomer, Jefferies appears to be struggling with volatility. The same may prove true for others that are downsizing their fixed-income businesses.
DRW Trading Group (DRW) is a principal trading organization. This means that all of our trading is for our own account and risk, and all of our methods, systems and applications are solely for our own use. Unlike hedge funds, brokerage firms and banks, DRW has no customers, clients, investors or third party funds. Our trading spans a wide range of asset classes, instruments, geographies and trading venues, with a focus on trading listed, centrally-cleared instruments.
Founded in 1992, our mission is to empower a team of exceptional individuals to identify and capture trading opportunities in the global markets by leveraging and integrating technology, risk management and quantitative research. With that spirit, DRW has embraced the integration of trading and technology by devoting extensive time, capital and resources to develop fast, precise and reliable infrastructure and applications. DRW has a flexible and entrepreneurial culture that cultivates creativity and practicality.
DRW is headquartered in Chicago and has offices in New York and London. DRW employs over 400 people worldwide from many different disciplines and backgrounds.
Morgan Stanley/Oliver Wyman, Wholesale & Investment Banking Outlook Global Banking Fractures: The Implications, here.
We believe the market actually over-estimates the extent of likely revenue erosion in Fixed Income. We anticipate the reforms will force $5-10bn of current revenue to migrate out of the sell-side by 2015. While this represents a 10-20% reduction in revenues in the most heavily affected areas (and still poses significant challenges for those like the IDBs with limited ability to offset), it is only 6-12% of the total OTC derivative pools of $75bn, and 3-5% of total sales & trading revenues. This compares with our proprietary investor survey which suggests investors expect 10-20% of FICC trading revenues to be affected by 2015. However, this is not to under-estimate the extent of value shift; the challenge for dealers in cleared markets is getting payback on the capital costs of providing clearing services, which is likely to underscore the importance of depth over breadth in client relationships. Much of this is still up for grabs – In our joint proprietary survey of institutional investors (see page 6) around 70% of buy-side firms had only completed on-boarding with one clearing member to date, despite around 65% indicating a plan to clear with multiple members.
Peter Tchir, TF Market Advisors, Treasuries, QE, Float & the Hotel California, here.
The Fed owns bonds with an average coupon of 3.6%, the rest of the world owns bonds with a 2.1% coupon. In part, this is because, of the average of the Fed’s portfolio (10 years, versus the rest of the world’s 5.2 years), but there is more going on than that.
The Fed owns 43% of all bonds with coupons of greater than 4.5%.
So the Fed has targeted higher coupon paper. The Fed’s average price of a bond (as of Thursday) was 117 versus 106. Again a lot can be explained by duration, but there is a concerted effort here to keep the governments costs low.
On Treasuries alone, the Fed added $57 billion to the budget. Without that direct contribution, the deficit would be $57 billion per annum more. This does NOT count in the ongoing calculations used by the OCB, but maybe it should?
There are additional benefits, both from non treasury holdings (mortgages, etc.) and from the low rates as a whole. What is that, another $50 billion in direct saving, and $100′s of billions in indirect savings?
So over the next 10 years, it seems likely the Fed will contribute $1 trillion of direct savings to the government by redeeming coupons, staggering. That is without the current plans to grow the Fed balance sheet by $85 billion a month.
The Fed has become a policy tool, and an important player in the budget. That was not the case as recently as 4 years ago. I’m not completely sure what it means, but I don’t think it is an accident, or “unintended consequence” so that has to be considered.
Matt Levine, DealBreaker, Deutsche Bank Had A Profitable Interest Rate Trading Business In 2008, here.
Again, though, I come at it the opposite way: if your business is based on manipulating rates, why are you running a matched book? There’s an intuitive plausibility to the Journal‘s basic tale of (1) bank put on big bets, (2) risk managers fretted, (3) they were reassured by traders saying “well we’ll just manipulate Libor so this bet pays off for us.” But if that was really the thinking, why not do it all the time? Why go through the effort of laying off 98% of your interest rate risk, building a mostly balanced book of long and short swaps, instead of just leaning really hard into bets on Libor going up, say, and then working the phones hard to push it up?
Avellaneda and Cont, Finance Concepts, Transparency in Over-the-counter Interest rate derivatives Markets, here. Marco is good to talk to on such things and he should be down at Courant/NYU unless he is traveling somewhere.
A major portion of interest rate derivatives, in particular interest rate swaps, is traded over the counter (OTC). This reports provides an overview of pre-trade and post-trade transparency in OTC interest rate derivatives markets. Focusing on the interest rate swap market, we pro- vide an inventory of existing forms of pre-trade and post-trade trans- parency in this market, discuss whether there is a need for increased transparency in this market, how such an increase in transparency may be achieved and to whom the costs and benefits would incur.
Fleming, et. al. , Federal Reserve Bank of New York, An Analysis of OTC Interest Rate Derivatives Transactions: Implications for Public Reporting, here. I think Fleming is the guy from the Fed US Treasury studies back in the day.
The frequency of trading activity affects the reliability of price reporting as a timely source of information for prospective investors trying to execute transactions in similar instruments. Even the most commonly traded instruments in our data set were not traded with a high degree of frequency. In fact, no single instrument in the IRS data set traded more than 150 times per day, on average, and the most frequently traded instruments in OIS and FRA only traded an average of 25 and four times per day, respectively.
Activity outside of relatively standardized contracts was highly dispersed and traded even less frequently. We found over 10,500 combinations of product, currency, tenor and forward tenor traded during our three month sample, with roughly 4,300 combinations traded only once. We also found a meaningful degree of customization in contract terms, particularly in payment frequencies and floating rate tenors. Because of the unique and disparate characteristics of some of these transactions, the publicly reported prices may provide limited pricing information for market participants.
Pontus Eriksson, Sungard, Do you really know how to price an interest rate swap? here. All these papers are going to dive right in to the idea of recovering risk-neutral pricing in light of Libor being a curve with a non trivial credit spread component. That is important. If you are coming from a Equity background where long and short positions in a stock leave you flat there is one big difference in the irs world in determining if your portfolio is flat. Instead of a stock price you need a Swap Curve(s) and a pricing function for discounting expected cash flows and projecting future floating rates. Once you know the swap curve you can use Taylor’s Theorem (a lot) to show that for small changes in the prices of instruments used to construct the swap curve leads to corresponding changes in the price of the portfolio. If you can balance your portfolio so that the perturbations in the underlying leave your first and second derivatives (of the pricing function) small as well as the delta in the portfolio price being small then you are “flat.” Some rates folks will call this monitoring the Risk Along the Curve. There are lots of ways to get your swap portfolio flat overnight – think of it as a new fancy objective function. Sungard is kind of like Calypso.
Similarly during the crisis, the spread between the EUR deposit rate and the overnight indexed swap (OIS) rate exploded, peaking at roughly the time of Lehman’s default. Since then the basis has shrunk, but it has not reached the levels seen before the crisis. This has led to the notion of OIS discounting.
JR Varma, An Introductory Note on Two Curve Discounting, here. References at the end are also good as i recall.
“Ten years ago if you had suggested that a sophisticated investment bank did not know how to value a plain vanilla interest rate swap, people would have laughed at you. But that isn’t too far from the case today.”
– Deus Ex Machiatto3, June 23, 2010
Hull and White, Libor vs. OIS: The Derivatives Discounting Dilemma, here. This paper is new to me.
Traditionally practitioners have used LIBOR and LIBOR swap rates as proxies for risk-free rates when valuing derivatives. This practice has been called into question by the credit crisis that started in 2007. Many banks now consider that overnight indexed swap (OIS) rates should be used for discounting when collateralized portfolios are valued and that LIBOR should be used for discounting when portfolios are not collateralized. This paper critically examines this practice. We show that it is not generally possible to handle credit risk by changing the discount curve.
SIFMA, Research, here. Look under Derivatives for the .xls results 10 trillion of 512 trillion USD interest rate derivative notional is 30+ years out maturity… 18 trillion 25+ years out maturity. That is quite a jump between 20 Apr 2012 and 11 May 2012 in outstanding 30+ notional 4.3 trillion to 12.8 trillion.
Ritholtz, The Big Picture, Long Interest Rates, 1790 to Present, here.
The great irony of the fiscal cliff settlement is that US borrowing rates are as cheap as they have been throughout the History of the US.
Now would be the least expensive time in most of your lifetimes to:
A) Rebuild the US infrastructure of Airports, Mass Transit, Ports, Waterways;
B) Upgrade and Secure the US Electrical grid, including making it more secure from hackers;
C) Improve the security of nuclear plants, ports, and chemical manufacturing plants;
D) Upgrade Roads, Bridges, Tunnels;
E) Improve public outdoor lighting, including “smarter” lights and traffic sensors
Cont, Mondescu & Yu, SSRN, Central Clearing of Interest Rate Swaps: A Comparison of Offerings, Mar. 2011, here.
Regulatory changes have motivated the development of a variety of solutions for the clearing of interest rate swaps. Margin payments associated with clearing lead to modifications in cash flows which result in differences in the valuation between cleared and non-cleared swaps. We propose a framework for computing these differences and show that they lead to two types of modifications in contract value: a convexity effect and a “Net Present Value” (NPV) effect, which can be significant for long-dated swaps. As a result, modifications in contract design are required in order for a centrally cleared interest rate swap to be economically equivalent to its uncleared counterpart. Among the currently available offerings for cleared interest rate swaps, three offerings are shown to be economically equivalent to their uncleared counterparts – the “Price Alignment Interest” method used by LCH. Clearnet and CME, as well as a new adjustment method used by the Eris Exchange – while a fourth method, used in the IDCG swap futures contract, is shown to lead to substantial deviations in valuation with respect to a non-cleared interest rate swap. Using a Hull-White model calibrated to the market data as of December 2010, we find the difference between the IDCG futures swap rate and the corresponding uncleared swap rate to be around 18 basis points for a 10 year contract and about 60 basis points for a 30 year contract. An interest rate environment with higher volatility will result in larger differences.
Ritholtz, Have Banks Been Manipulating Libor for DECADES, here. Data is always harder and trickier than you think. Philosophically, if there was libor manipulation prior to the general use of email, would it matter? Discuss amongst yourselves.
Derek Thompson, The Atlantic, The 11 Ways That Consumers Are Hopeless at Math, here.
In his book Priceless, William Poundstone explains what happened when Williams-Sonoma added a $429 breadmaker next to their $279 model: Sales of the cheaper model doubled even though practically nobody bought the $429 machine. Lesson: If you can’t sell a product, try putting something nearly identical, but twice as expensive, next to it. It’ll make the first product look like a gotta-have-it bargain. One explanation for why this tactic works is that people like stories or justifications. Since it’s terribly hard to know the true value of things, we need narratives to explain our decisions to ourselves. Price differences give us a story and a motive: The $279 breadmaker was, like, 40 percent cheaper than the other model — we got a great deal! Good story.
Streetwise Professor, The Truth About LIEBOR is Coming Out, here. Didn’t UST yields and USDLibor invert for bit in 2008-9? I think the “actually distorting Libor” question is going to be a slam dunk easy decision. Let’s take the short rate from the BBA and bring the trustworthy successor to Libor back the US of A. You need a team who knows what’s going on in finance to be in charge of new trustworthy USDLibor. How about USD Libor co-heads, Matt Taibbi and Dick Fuld?
Perhaps crucially, the Order only finds that Barclay’s attempted to manipulate, not that it had in fact succeeded. This will be an important issue going forward. To prove manipulation, and crucially, to collect damages, it will be necessary to show that Barclay and other submitters of LIBOR quotes indeed distorted the index, that is, they caused an artificial price in a futures contract based on LIBOR or some other interest rate like Euribor.
THE most memorable incidents in earth-changing events are sometimes the most banal. In the rapidly spreading scandal of LIBOR (the London inter-bank offered rate) it is the very everydayness with which bank traders set about manipulating the most important figure in finance. They joked, or offered small favours. “Coffees will be coming your way,” promised one trader in exchange for a fiddled number. “Dude. I owe you big time!… I’m opening a bottle of Bollinger,” wrote another. One trader posted diary notes to himself so that he wouldn’t forget to fiddle the numbers the next week. “Ask for High 6M Fix,” he entered in his calendar, as he might have put “Buy milk”.
Stephanie Flanders, BBC News, Inconvenient truths about Libor, here. Stephanie is correct, it is time to straighten up and fly right. No more Cat in the Hat like quotes from senior government officials pertaining to the usefulness of Libor, when there are several $100 TN of notional contracts outstanding tied to Libor.
“It is in many ways the rate at which banks do not lend to each other, and it is not clear that it either should or does have significant operational content. I think it is convenient, very often, for people to justify what they do for other reasons, in terms of Libor, but it is not a rate at which anyone is actually borrowing. It is hard to see how it can actually have much of an impact.”
And yet, despite their inherent fuzziness and lack of “significant operational content”, despite the lack of formal checks on banks’ internal procedures for coming up with these rates, Euribor and Libor are the benchmark for pricing transactions worth trillions of dollars. US dollar Libor, for example, is the basis for the settlement of the three-month Eurodollar futures contract, which had a traded volume in 2011 with a notional value of $564 trillion, according to the CFTC.
The Aleph Blog, An Analysis of Three-Month LIBOR 2005-2008, here. Uh oh, Barcap is statistically in the coalition to pull Libor up. That’s going to leave a mark! Wasn’t Diamond’s testimony problem that the 14 bad traders were marking their borrowing rate lower than the actual Barcap borrowing rate? It would make financial sense if Barcap was at the high end of the Libor in 2008 because the credit situation was deteriorating and everyone’s credit spreads were blowing out. It is plausible the Barcap’s spreads were widening faster than say JPM’s in the heat of the credit crisis… and so students one more example of why it is bad to be in charge of data. The Barcap employees eventually lost their jobs because of the public outrage stemming from:
1. Barcap spreads were either higher or lower than their actual unsecured funding rate (e.g., the true rate at which no one would lend to them),
2. Libor was no longer useful as the proxy for unsecured AA “risk free” borrowing (because there were no AA banks left to lend or borrow at the wider ultra-risky “risk free” spreads) and
3. The traders sent bro mail to each other discussing 1 and 2 above.
I downloaded the data for LIBOR over the period 2005-2008, and decided to run regressions of the 3-month rates submitted from each bank versus 3-month LIBOR, since I think it is the most commonly used. Here are the results: