Help with Base Rate SWAP Trade

[jackal007]

Right, so these are both deals where you pay fixed and receive base. It's easy enough to hedge these, but the exact size of the hedge is hard to determine without knowing the details of the amortization schedule. Moreover, it's also difficult to tell the current PV of these two trades without knowing the amortization details. If the total fair value PV of the trades is close to what the bank wants to charge you for the unwind, you should just unwind them. So the only thing that remains to be determined is what happens to the principal amounts on these trades every time there's a payment.

Martinhoul

Received a reply from bank today with this info.

1st swap covers £340,940.52 and has a break cost of £52,000. 2nd currently covers £904,210.04 and has a break cost of £132,000;

Both trades are amortising with monthly resets;

They are both fixed for floating interest rate swaps;

I have requested the reset advices (whatever they are), and also amortization schdules on both swaps, but not sure if they can provide them.

I really thought this would just be a matter of selling some interest rate options each month, of an amount which would approximate the balance on each swap, i.e. £1.245m. If rates moved up I will still be hedged because the swap rates would be bound to move as well. If the swaps are a long trade in one direction then i must be able to make a short trade in the opposite direction?

Jackal

 

[Martinghoul]

So I tried to price these two or rather I tried to price two trades that are as close to what you have described as I could. Attached are the two screenshots that show the current fair mkt value of the two deals (assuming no amortization, since we don't know the schedule).

There's things you can do to hedge them, but you need to be aware of the following points:
1) If you hedge the interest rate component of the two trades, you're going to be effectively locking in the current PVs
2) You're going to incur all sorts of frictions (e.g. you're going to have to pay to roll the hedge, potentially post margin, etc)
3) Your hedge will not be perfect
4) If it's an imperfect hedge (i.e. you selling some options), you're going to be exposed to all sorts of potentially unpleasant risks

So three options I think you should consider:
1) Run the trades, given that you benefit from rate rises in the UK, which are becoming increasingly likely. Your exposure (again assuming no amortizaton) is arnd £1150 per bp, so every time Swervin' Mervyn raises rates by 25bps your unwind PVs improve by arnd £30k. Unless you think rates are going further down (which is possible, but highly unlikely), your sole downside is if Swervin' Mervyn drags his feet.

2) Bite the bullet and pay the evil Scots the unwind fees, here and now. It is the cleanest solution by far, but, obviously, means you pay.

3) Hedge and incur the issues/run the risks I described above.

So pick yer poison.

P.S.: I think by "reset advices" they mean the schedule of cashflows with all the relevant dates (i.e. fixing date, payment date, as well as the accrual period start and end dates).

 

[jackal007]

So I tried to price these two or rather I tried to price two trades that are as close to what you have described as I could. Attached are the two screenshots that show the current fair mkt value of the two deals (assuming no amortization, since we don't know the schedule).

There's things you can do to hedge them, but you need to be aware of the following points:
1) If you hedge the interest rate component of the two trades, you're going to be effectively locking in the current PVs
2) You're going to incur all sorts of frictions (e.g. you're going to have to pay to roll the hedge, potentially post margin, etc)
3) Your hedge will not be perfect
4) If it's an imperfect hedge (i.e. you selling some options), you're going to be exposed to all sorts of potentially unpleasant risks

So three options I think you should consider:
1) Run the trades, given that you benefit from rate rises in the UK, which are becoming increasingly likely. Your exposure (again assuming no amortizaton) is arnd £1150 per bp, so every time Swervin' Mervyn raises rates by 25bps your unwind PVs improve by arnd £30k. Unless you think rates are going further down (which is possible, but highly unlikely), your sole downside is if Swervin' Mervyn drags his feet.

2) Bite the bullet and pay the evil Scots the unwind fees, here and now. It is the cleanest solution by far, but, obviously, means you pay.

3) Hedge and incur the issues/run the risks I described above.

So pick yer poison.

P.S.: I think by "reset advices" they mean the schedule of cashflows with all the relevant dates (i.e. fixing date, payment date, as well as the accrual period start and end dates).

Martinhoul
I now realise by advcies they simply mean the monthly advice notes, telling me what the debit is going to be that month. Ive attached the latest two, as for some reason October was the last month I received the hard copies in the post, dont know why. I also have the full amortization schdules for both swaps, which Ive also attached. Dont know if this changes anything for the proposed trade?
Jackal

 

[Martinghoul]

Martinhoul
I now realise by advcies they simply mean the monthly advice notes, telling me what the debit is going to be that month. Ive attached the latest two, as for some reason October was the last month I received the hard copies in the post, dont know why. I also have the full amortization schdules for both swaps, which Ive also attached. Dont know if this changes anything for the proposed trade?
Jackal

It might change the current fair value PV, so we may discover, surprise surprise, that the evil Scots are looking to charge you hefty bid/offer on the unwind (as expressed by the difference between their proposed "break cost" and the fair value PV). This may affect which of the three choices you deem more palatable. Let me try to price the swaps using the correct amortisation schedule (I hope I can) and you figure out what makes more sense to you.

 

[Martinghoul]

Right, here are the two "fair value" PVs using the amortization schedules you provided and correct dates, etc. I would say that these PVs are accurate to within give or take around £3.5k (two reasons: a) I can't easily do the exact monthly amortization and have to contend with annual; b) I am pricing a SONIA swap, rather than a base rate one).

So, essentially, the "fair value" PV of your portfolio is -£230.5k, i.e. you owe the evil Scots that money. Therefore, if they're asking you to pay £300k to unwind, they're charging you a £70k fee (let's call it bid/offer), which is smth like 30% of the portfolio's current fair value. Needless to say, that's highway robbery, but we suspected that already. The decision you have to make is which of the alternatives I have outlined in my previous posts look the most palatable to you.

P.S.: Actually, I lie... I can do monthly amortization, but that's a lot of data to enter. If you really want me to, I can do it, but I think you get the general idea anyways.

 

[mikmo]

PV on Swap 1 is £49,0004. PV on Swap 2 is £124,462.

So current total £173,467. Rates have come a bit higher since Martinghoul priced and I'm using the exact profile.

RBS would pay a basis point or two in execution so call it £175k cost to them to break you.

Personally I think rates will stay low for way longer than the curve is currently pricing so I'd be inclined to pay for a break. Plus by breaking and reducing the tenor, RBS should reduce their credit spread. So say they charged you 25bps over the life of the 15yrs, which you will pay as you make each settlement, tell them to break you at a lower credit spread as the risk was ultimately less than 15yrs.

 

[mikmo]

Note that they will need to charge some credit spread in their break BUT 300k is way excessive.

 

[meanreversion]

Personally I think rates will stay low for way longer than the curve is currently pricing so I'd be inclined to pay for a break.

Fairly minority view, what makes you think this? I'm not disagreeing with you per se, I just wondered as to your logic.

 

[mikmo]

I find myself fairly bearish on the immediate recovery. Public job cuts, rash legislation and retoric targetting the UK's leading industry (finance), property price stability artifically maintained by ultra low rates... etc. I think the demand drag of raising rates is too great given the fragility of the situation.

Inflation is the elephant in the room I guess.

 

[meanreversion]

The situation certainly is fragile. The other elephant in the room is that the so-called "cuts" are anything but, with borrowing for November "unexpectedly" high at £23bn. The coalition is talking tough, but have yet to make any meaningful inroads to public expenditure, despite the rhetoric.

It's interesting to note that our trade deficit is now "unexpectedly" high, despite sterling's fall over the last couple of years. I really do wonder what the UK's edge is these days.. we've managed to squander much of what made this country great, and now seem intent on surrendering all powers to Brussels.

 

[Martinghoul]

I am actually with mikmo on this and 'twould be good to have a discussion, but let's not hijack this thread, gents? This is a decision for jackal, who has to pick which alternative is of most utility to him/her.

 

[meanreversion]

It seems fairly clear the UK is trying to inflate its way out of trouble. Wage settlements are now running at 1.4%, a good 2-3% below inflation, ergo effective pay cut. On that basis, I'd be inclined to agree they'll try to keep rates as low for as long as possible.

On a different note, commendable amount of work on this thread, M'ghoul.. does it take long to price those swaps up?

 

[meanreversion]

How can analysts be so far off? Looks like nothing is changing any time soon on the spending front. We've already had insurrection and riots, and spending has hardly been touched lol

http://www.guardian.co.uk/business/2010/dec/21/budget-deficit-november-2010

 

[Martinghoul]

On a different note, commendable amount of work on this thread, M'ghoul.. does it take long to price those swaps up?

Nah, it's not too bad at all, thank BBG... The amortisation schedule is a pain in the ****, so that's why I only did it annually.

Shall we have another thread on the bank rate and Swervin' Mervyn? Would be nice... I can start it.

 

[mikmo]

SD is an interesting platform if you do much pricing M'ghoul.

I'll pop into the bank rate thread if you've put one up.

 

[meanreversion]

Does it exist yet?

We've had Steady Eddie (George) and now Unswervin' Mervyn.. how come no-one else nicknames their central bankers?

 

[Martinghoul]

Nah, not yet... Will do today. And yes, I played with SD and it has some issues.

 

[meanreversion]

SD = Superderivatives?

 

[Martinghoul]

Yep, SuperDs...

 

[mikmo]

Oh really? I've found it really accurate for finding mids, although had a few issues with the delta accuracy. What issues have you had? Would be interested to hear opinions on the platform.