Understanding Deliverable Swap Futures Trading and Risk Management with DSF
Disclaimer Futures trading is not suitable for all investors, and involves the risk of loss. Futures are a leveraged investment, and because only a percentage of a contract’s value is required to trade, it is possible to lose more than the amount of money deposited for a futures position. Therefore, traders should only use funds that they can afford to lose without affecting their lifestyles. And only a portion of those funds should be devoted to any one trade because they cannot expect to profit on every trade. The Globe Logo, CME®, Chicago Mercantile Exchange®, and Globex® are trademarks of Chicago Mercantile Exchange Inc. CBOT® and the Chicago Board of Trade® are trademarks of the Board of Trade of the City of Chicago. NYMEX, New York Mercantile Exchange, and ClearPort are trademarks of New York Mercantile Exchange, Inc. COMEX is a trademark of Commodity Exchange, Inc. CME Group is a trademark of CME Group Inc. All other trademarks are the property of their respective owners. The information within this presentation has been compiled by CME Group for general purposes only. CME Group assumes no responsibility for any errors or omissions. Although every attempt has been made to ensure the accuracy of the information within this presentation, CME Group assumes no responsibility for any errors or omissions. Additionally, all examples in this presentation are hypothetical situations, used for explanation purposes only, and should not be considered investment advice or the results of actual market experience. All matters pertaining to rules and specifications herein are made subject to and are superseded by official CME, CBOT, NYMEX and CME Group rules. Current rules should be consulted in all cases concerning contract specifications.
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Outline • About Deliverable Swap Futures • Delivered Swap • Futures Quote Convention • Measuring Risk • Hedge Ratio • Hedging Spot OTC Swap • DSF as IRS Proxy • Spreading vs. Cash Treasuries • Spreading vs. Treasury Futures
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About Deliverable Swap Futures “Futurization”… • Dodd Frank bill promotes convergence of exchange traded futures with OTC derivatives trading and clearing practices • Mandatory clearance of standard OTC derivatives is step toward futures world
• DSF is leading example of how futures are being designed to more closely resemble IRS
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Exchange Traded Futures
“Futurization” Convergence of Trading & Clearing Practices Over-theCounter (OTC) Derivatives
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About Deliverable Swap Futures
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5% 4% 3% 2% 1%
2-Yr Swap
5-Yr Swap
10-Yr Swap
Jan-12
Jan-11
Jan-10
Jan-09
Jan-08
Jan-07
Jan-06
Jan-05
Jan-04
0% Jan-03
• Deliverable Swap Futures (DSF) offer vehicle for taking interest rate swap (IRS) exposures … with transparency, liquidity, capital efficiencies, financial sureties of futures
6%
Jan-02
• Subprime mortgage crisis prompted adoption of Dodd Frank financial reforms … calling for greater transparency and financial sureties
Swap Rates
7%
Jan-01
Dynamic environment …
30-Yr Swap
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About Deliverable Swap Futures Key benefits … • DSF launched 12/3/12 with strong initial results, offering • Flexible execution thru Globex, blocks, EFPs, open outcry
40,000 35,000 30,000 25,000
• Risk offsets vs. Eurodollar & Treasury futures
20,000
• Simplicity of futures documentation, reporting and infrastructure
10,000
• Generally ½ bip wide markets
0
• Utilized by banks, hedge funds, asset managers & prop shops
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Deliverable Swap Futures Activity
15,000
5,000 Dec-12
Jan-13
Feb-13
Average Daily Volume (ADV)
Mar-13
Apr-13
Open Interest (OI)
6
About Deliverable Swap Futures 5%
Classic T-Bond 15-25 Yrs
Eurodollars 0-10 Years
4% 2-Yr DSF
3%
5-Yr T-Note
Blanketing the Yield Curve CME Group interest rate products include Eurodollars, Treasury, on-the-run (OTR) Treasury, DSF & Fed Fund based products
2-Yr T-Note 5-Yr DSF
30-Day Fed Funds
30-Yr DSF
10-Yr DSF
3-Yr T-Note
2%
1%
Ultra Bond 25-30 Yrs
10-Yr T-Note
30-Yr
10-Yr
7-Yr
5-Yr
3-Yr
2-Yr
1-Yr
6-Mth
3-Mth
0%
(U.S. Treasury Yield Curve as of 2/1/11)
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About Deliverable Swap Futures DSF Basics … • DSFs call for delivery of 2-, 5-, 10- or 30year IRS of $100,000 face value and cleared by CME Clearing House • Coupons established by Exchange at levels near market rates, e.g., 0.5%, 1.0%, 1.5%, 2.0%, etc. • Delivery occurs on Monday prior to 3rd Wednesday in contract months of March, June, September and December
Reference Conventions DSF Contracts
Delivered or Actual IRS
Delivery
Buyer (Long)
Fixed Rate Receiver (Floating Rate Payer)
“Takes” Delivery
Seller (Short)
Fixed Rate Payer (Floating Rate Receiver)
“Makes” Delivery
• Quoted as 100% of par plus Non-Par Value (NPV) of delivered swap … NPV paid upon delivery as IRS established by book entry at Clearing House
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Delivered Swap Trading Unit
$100,000 notional face value Interest Rate Swap (IRS), cleared by CME Clearing House, with 2-, 5-, 10- or 30-year tenors, exchanging semiannual fixed payments at Contract Fixed Rate for quarterly floating payments based on 3-month LIBOR
Delivery Months
March, June, September or December
Fixed Rate
Established by Exchange at integer multiples of 25 basis points with 30/360 day count fraction
Quote Convention
Last Trading Day
In % of par: 100 points + net present value (NPV) of IRS where NPV is present value of IRS fixed-rate payments minus present value of IRS floating-rate payments as of Delivery Day 2-Year 1/4th of 1/32nd of 1% of $100,000 ($7.8125) 5-Year ½ of 1/32nd of 1% of $100,000 ($15.625) 10-Year 1/32nd of 1% of $100,000 ($31.25) 2 pm (CT) on 2nd London business day before 3rd Wednesday of futures Delivery Month
Delivery Day
3rd Wednesday of Delivery Month
Tick Size
Delivery Standard
References Reference Tenors Notional Amount IRS Effective Date Termination Date Fixed Pay Dates Fixed Rate Floating Pay Dates Floating Rate
Fixed Rate Payer “short” & “makes” delivery, Floating Rate Payer “long” & “takes” delivery 2-, 5-, 10- and 30-Year IRS Instruments $100,000 (USD) per futures contract 3rd Wednesday of Delivery Month Anniversary of IRS Effective Date at futures Reference Tenor Semiannually from IRS Effective Date on 30/360 day count Established by Exchange at integer multiples of 25 basis points Quarterly from IRS Effective Date on Actual/360 day count BBA 3-Month USD LIBOR with no spread or compounding
“Book-entry” delivery of IRS; Clearing Acceptance & Effective Date = 1st Business Day before 3rd Wednesday of Delivery Month Delivery Method
Invoice Price = IRS Initial Payment Amount, per Final Settlement Price (P) If 100 < P, IRS Floating Rate Payer pays, and IRS Fixed Rate Payer receives, $1,000 x ( P – 100 ) per contract If P ≤ 100, IRS Fixed Rate Payer pays, and IRS Floating Rate Payer receives, $1,000 x ( 100 – P ) per contract
Delivery Eligibility Trading Hours
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Limited to Eligible Contract Participants (ECPs) per Section 1a(18) of the Commodity Exchange Act CME Globex 5:00 pm to 4:00 pm, Sun-Fri Open Outcry 7:20 am to 2:00 pm, Mon-Fri
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Futures Quote Convention Quoted as NPV …
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0.33%
0.35%
0.40%
0.37%
0.32% 0.25%
0.30% 0.14% 0.14%
0.14%
0.17%
0.18%
0.21%
0.16%
0.10%
Forward Curve Source: Bloomberg
3/1/15
1/1/15
11/1/14
9/1/14
7/1/14
5/1/14
3/1/14
1/1/14
0.00% 11/1/13
• Discount rates may be estimated by Overnight Index Swap (OIS) curve
0.40%
0.20%
0.54%
0.42% 0.45%
9/1/13
• Floating payments @ 3-month LIBOR … may be estimated by LIBOR forward curve
0.50%
7/1/13
• Fixed payments at coupon fixed by Exchange
0.49%
5/1/13
NPV = PV(fixed) – PV(floating)
0.60%
3/1/13
• DSFs quoted as NPV of delivered swap
Forward LIBOR Curve and OIS Curve
OIS Curve
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Futures Quote Convention Mar-13 Two-Year DSF w/ 0.50% Coupon
Example … • Calculate NPV of 2-year IRS with 0.5% coupon • NPV = $154.38 per analysis Quote = 100% + NPV in % of par = 100% + ($154.38/$100,00) = 100-5/32nds
• What if NPV = -$1.344? Quote = 100% + (-$1,344/$100,00) = 98-21/32nds
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( As of 11/27/12) Payment Date
Fixed Payment
Floating Payment
Net Payment
Discount Factor
Present Value
3/20/13
$0.00
$0.00
$0.00
0.999548
$0.00
6/20/13
$0.00
$84.10
-$84.10
0.999196
-$84.03
9/20/13
$250.00
$89.01
$160.99
0.998833
$160.80
12/20/13
$0.00
$92.92
-$92.92
0.998441
-$92.78
3/20/14
$250.00
$98.85
$151.15
0.998025
$150.85
6/20/14
$0.00
$106.97
-$106.97
0.997565
-$106.71
9/22/14
$252.78
$118.16
$134.62
0.997009
$134.22
12/22/14
$0.00
$123.98
-$123.98
0.996389
-$123.53
3/20/15
$247.22
$131.15
$116.07
0.995600
$115.56 $154.38
Source: Bloomberg
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Measuring Risk Key risk measures … • Duration … • Macauley’s duration = average weighted maturity of cash flows (coupons, principle) discounted to PV • Modified duration = % price change per 1% yield change
• Basis point value (BPV) … • Dollar change in value given a one basis point (0.01%) change in yield • Often quoted in $’s per $1 mil in face value • AKA “dollar value (DV) of 01”
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On-the-Run Treasuries (November 27, 2012)
Tenor
Coupon
Maturity
Duration
2-Year 3-Year 5-Year
1/4% 3/8% 3/4%
10/31/14 11/15/15 10/31/17
1.916 2.945 4.824
BPV (per mil) $192 $295 $485
7-Year
1-1/4%
10/31/19
6.614
$670
10-Year
1-5/8%
11/15/22
9.158
$915
30-Year
2-3/4%
11/15/42
20.258
$2,012
Source: Bloomberg
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Hedge Ratio Hedge objective … • Balance losses (gains) in cash value with gains (losses) in futures … must find Hedge Ratio (HR) that achieves this balance ΔHedge = Hedge Ratio (HR) x ΔDSF
• Using Δ to denote change in value and solving for Hedge Ratio HR = Δhedge / ΔDSF
• Substitute BPV for abstract concept of “change in value HR = BPVhedge / BPVDSF
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Hedge Ratio Mar-13 Two-Year DSF w/ 0.50% Coupon Assuming Yields Rise 1 Basis Point
Find BPV of DSF … • Key to calculating HR is measuring risks
( As of 11/27/12) Payment Date
Fixed Payment
Floating Payment
Net Payment
Discount Factor
Present Value
• Simulate NPV of delivered swap if rates rise 1 bip
3/20/13
$0.00
$0.00
$0.00
0.999517
$0.00
6/20/13
$0.00
$86.66
-$86.66
0.999139
-$86.58
9/20/13
$250.00
$91.57
$158.43
0.998751
$158.24
• Assume rates rise uniformily across LIBOR and OIS forward curves
12/20/13
$0.00
$95.45
-$95.45
0.998334
-$95.29
3/20/14
$250.00
$101.35
$148.65
0.997893
$148.34
6/20/14
$0.00
$109.53
-$109.53
0.997407
-$109.24
9/22/14
$252.78
$120.77
$132.01
0.996825
$131.59
• NPV falls from $154.38 to $134.13
12/22/14
$0.00
$126.51
-$126.51
0.996180
-$126.02
3/20/15
$247.22
$133.59
$113.63
0.995367
$113.10
BPV = $154.38 - $134.13
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$134.13
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Hedging Spot OTC Swap Constructing hedge … • Buyer or fixed rate receiver of IRS instrument exposed to risk of rising rates … must sell DSFs • Seller or fixed rate payer of IRS instrument exposed to risk of falling rates … must buy DSFs
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Hedging Tactics IRS Instrument
DSF Contracts
Buyer or Fixed Rate Receiver
Sell DSF Contracts
Seller or Fixed Rate Payer
Buy DSF Contracts
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Hedging Spot OTC Swap Example … • Hedge $10 million notional value of 1.65% coupon 10-year IRS as of 11/28/12 … NPV = $4,625 … BPV = $9,567 • Hypothetical 10-year DSF with 2% coupon had BPV = $99.21 per contract
Scenario Analysis NPV and (Profit/Loss) on Position
Rates
Long $10 mil IRS
Short 96 DSF
Net P/L
+0.25%
NPV = -231,467 P/L = -$236,092
Aggregate NPV = $1,199 P/L = +$234,918
-$1,174
0.00%
NPV =$4,625 P/L = $0
Aggregate NPV = $236,117 P/L = $0
$0
-0.25%
NPV = $246,915 P/L = +$242,290
Aggregate NPV = $477,473 P/L = -$241,356
+$934
HR = $9,567 / $99.21 = 96.43 or SELL 96 contracts
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DSF as OTC Proxy Capital efficiencies … • DSFs may be deployed as economically equivalent proxy for portfolio of IRS
Margin Savings (% of Notional Value) (Estimated in Apr-13)
Tenor
Cleared IRS
DSF
Savings
• Advantages include …
2-Year
0.49%
0.13%
74%
• Effective auto-netting
5-Year
2.02%
0.93%
54%
• Minimize line items on books
10-Year
3.60%
1.95%
46%
• Reduced transaction costs
30-Year
8.98%
4.90%
45%
• Margin savings
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Spreading vs. Cash Treasuries Example … • Match risk of $10 million face value of 10-year on-the-run 1-5/8% Treasury of 2022 as of 11/28/12 … BPV = $9,180 • Hypothetical 10-year DSF with 2% coupon had BPV = $99.21 per contract
Credit Conditions Improving
SELL Treasuries
BUY Swaps &
Credit Conditions Deteriorating
SELL Swaps & BUY Treasuries
HR = $9,180 / $99.21 = 92.53 or SELL 93 contracts
• This constitutes private vs. public credit risk spread
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Spreading vs. Cash Treasuries Credit spread gone awry?
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2-Yr Spread 10-Yr Spread
Nov-12
Jun-12
Jan-12
Aug-11
Mar-11
Oct-10
May-10
Dec-09
Jul-09
Feb-09
Sep-08
Apr-08
Subprime Mortgage Crisis
Nov-07
• Pension funds & insurance companies with LT liabilities embracing “liability-driven investment” (LDI) … matching asset & liability terms … pushing 30-year IRS rates lower
US Debt Ceiling More Crisis Euro Debt Crisis
Euro Debt Crisis
Jun-07
• IRS at par implies no current credit exposure to counterparty while Treasuries require cash investment
Jan-07
• Too big to fail policy converges public and bank credit risks
Swap over Treasury Spreads
1.6% 1.4% 1.2% 1.0% 0.8% 0.6% 0.4% 0.2% 0.0% -0.2% -0.4% -0.6%
5-Yr Spread 30-Yr Spread
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Spreading vs. Treasury Futures Example … • BPV of Treasury futures is function of CTD security BPVTreasury Futures = BPVCTD / CFCTD
• CTD 10-year T-note vs. Mar-12 10-year note futures was 3-3/8% of 2019 as of 11/28/12 … BPV = $72.90 with CF= 0.8604 • Match with hypothetical 10-year DSF with 2% coupon … BPV = $99.21 HR = (BPVCTD / CFCTD) / BPVDSF = ($72.90/0.8604) / $99.21 = 0.85
• Spread 10-year DSF:10-year Treasury futures in 17:20 ratio • Again, note credit spread element of trade Yield Curve Steepening
SELL 10-year DSFs & BUY 10-year Treasury futures
Yield Curve Flattening
BUY 10-year DSFs & SELL 10-year Treasury futures
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Supplementary Slides
Useful CME Group Links Strategy Papers www.cmegroup.com/education/risk-management-for-fixed-income-asset-managers - Treasury Futures www.cmegroup.com/trading/interest-rates/files/IR-314_EurodollarRiskMgmtTools_SR.pdf - Eurodollars www.cmegroup.com/education/option-fundamentals-for-fixed-income-asset-managers - Option Basics www.cmegroup.com/education/files/Treasury-Option-Strategies.pdf - Treasury Options Strategies
www.cmegroup.com/education/featured-reports/cme-clearing-invoice-swaps-margin-efficiencies - Invoice Swaps Products www.cmegroup.com/education/featured-reports/understanding-treasury-futures www.cmegroup.com/ultra - Ultra Treasury Bond Futures Home Page www.cmegroup.com/dsf - Deliverable Swap Futures www.cmegroup.com/trading/interest-rates/stir/eurodollar-options.html - Mid-Curve Options
Other Useful Links www.cmegroup.com/yield - CME Group Yield Center www.cmegroup.com/trading/interest-rates/order-execution/main -Liquidity Tool www.cmegroup.com/trading/interest-rates/duration - Treasury Futures Empirical Duration Tool www.cmegroup.com/trading/interest-rates/intercommodity-spread - Intercommodity Treasury Spreads www.cmegroup.com/trading/interest-rates/paceoftheroll/index - Pace of the Roll
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