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Yields, Swaps, &CorpFin

Paul Laux

Teaching thoughts Yields, Swaps, Yield curves Swap pricing &CorporateFinance Corporate finance More teaching Financing Tactics Teaching with Bloomberg thoughts

Paul Laux

Exelon Center Labs Conference University of Delaware

August 2013 Yields, Swaps, Gratitude &CorpFin Paul Laux

Teaching thoughts

Yield curves

Swap pricing Thanks, Rich, for our Conference. Corporate finance More teaching thoughts Thanks to all of you for the opportunity to show you some of my teaching ideas. Yields, Swaps, Stage setting &CorpFin Paul Laux

Teaching thoughts

Yield curves The teaching application I have to is from Swap pricing Corporate finance an undergraduate capstone course, “Advanced More teaching .” As a capstone, the point thoughts is to integrate the students’ prior learning and send them on their way to apply it. Especially, the course links financial markets to corporate finance applications. This application specifically links yields and interest rates to swaps to corporate financing opportunities. Yields, Swaps, Outline &CorpFin Paul Laux

Teaching thoughts 1 Teaching thoughts Yield curves

Swap pricing 2 Yield curves Corporate finance More teaching thoughts 3 Swap pricing Swap Manager intro The value of fair value

4 Corporate finance Benchmarking borrowing costs Application to fixed rate loans

5 More teaching thoughts Yields, Swaps, Thoughts on a teaching approach &CorpFin Paul Laux

Never miss the chance to reinforce and Teaching thoughts link the basics to practice; “Everything I Yield curves needed to know I learned in...” Swap pricing Example:Yield curves poster—assigned as Corporate finance More teaching pre-work, review in a prior class or podcast thoughts Bloomberg analytics apps build finance concepts into practical form, e.g., as in Swap Manager for swap pricing The details can be a bit intense, but also open doors for extended study later Markets solve problems...interest rate and swap markets solve corporate finance problems information is of practical help even for those who may never transact in the specific market Yields, Swaps, The big picture of yield curves... &CorpFin Paul Laux ... reinforcing and extending with little pictures: see paper poster ... can’t use swaps unless can use interest rate reasoning Teaching thoughts Yield curves

The forward curve matrix: Type FWCM , and specify a curve family, like I23 US Treasury Actives, US Treasury coupon-paying From spot curves to implied forward rates of interest Understanding yield curves, with help from Bloomberg. bonds. Swap pricing

Bloomberg's Corporate finance curve finder -- type CRVF -- provides access to a long list of yield curves. you can search by keyword, or lookup by country. Bloomberg refers to the curves by ID More teaching number. Prominent curves are the I25 US Treasury , and the S23 US dollar denominated swaps thoughts curve (of which more elsewhere on this page). When you know the curve you want, one way to get started with it is to type GC , for "Graph Note that the implied curves." You can then forward curves are all enter the ID number of upward sloping. That the curve that interests you, and suggests that, at each obtain a chart. The date, the economy has The chart shows rest of this page is to several snapshots of expected interest rates for help you understand the "forward curve." In specific periods farther some of the key yield order, from top to curves you will want to into the future to be bottom, they are from use. 10 years ago (white), 5 higher than for periods years ago (green), 1 closer to the present. Of year ago (blue, barely course, the succession of visible) and Mar 2013 curves (each one lower (now or 'spot'--meaning the spot time not spot than the previous one) curve). Interest rates says it has not turned out have been falling all that way. If the Fed decade long! controls rates with and QE, this suggests their actions have been unanticipated. Or perhaps market forces, which are harder to anticipate, have been more important.

Swap curves: Plain vanilla interest rate swaps promise the periodic payout (or receipt) of a floating rate cash flow (often at a LIBOR rate) in return for the periodic receipt (or payout) of a fixed rate cash flow. The fixed interest rate used to compute the The green lower fixed rate receipt is called the "swap rate." The swap rate is what market participants bargain about, as it sets the present value of the swap. Eyes-wide-open bargaining will lead to a swap with zero NPV at the start. Later, as interest rates change, curve is the I25 Treasury actives one party will tend to win or lose as the NPV rises or falls, and the swap becomes "off market" rate. coupon paying curve. The blue The curves below are swap curves, showing swap rates for plain vanilla swaps of different tenors (or lengths of agreement). In upper curve is these swaps, the exchanges happen semi-annually. Two swap curves are shown--one relative to EUR LIBOR (with payments in EUR), and one relative to USD LIBOR (with payments in USD). The Treasury curve is shown for comparison. the I39 US Strips curve. Swap curves depend on both spot and forward curves. They depend on spot curves because future cash flows must be The green top discounted to determined their value---a job for which spot curve rates are well suited. They depend on forward curves This GC graph curve is the S23 because the future payments on the floating leg depend on future interest rates---and forward curves give us a sense for expected future interest rates. shows the I25 USD swap curve. Treasury "actives" The red curve yield curve, which has usually in the coupon-paying T The bottom panel shows middle is the I25 YTMs. The chart also the spread between the Strips coupon Treasury shows the yield curve curve and the Treasury actives curve. The blue for Treasury Strips. A curve. The spread is always curve at the Treasury Strip is a positive. This will always be bottom is the S45 pure-discount (zero- the case for an upsloped EUR swap curve. coupon) bond version coupon curve. The reason is of a TBond, with only that the coupon curve is really one cash flow, at an average of the spot curve The bottom panel shows interest rate time. The elements for all dates up to the differential between the various Strips curve is one maturity, since the coupon curves. In this picture, the US swap case of a spot curve. bonds has cash flows at all curve is subtracted from each of the One way to think those dates. The near-in dates other curves. S23 - I25 would be about a coupon bond have spot curve yields that are called the "swap spread," so is that it is really a lower than the ones that are Bloomberg's red curve (shown by collection of strips or further out in maturity. default--I made no special choices zeros, engineered to on this GC screen) is the negative of have just the right the swap spread. (Also note that red payouts at each time. and blue have different meanings in the top panel vs. the bottom.) Details of the recent shape and changes in The snapshots Swaps are usually quoted for a AA the USD swap curve (at on this page credit situation. Thus it may seem left) and EUR swap were taken in What are spot curves useful for? When you know the yield off the spot curve, you natural that USD swap rates are curve (above). The long March 2013. know how to form the present value of a dollar received at that date. Just form the discount higher than Treasuries. But it needn't end of the USD swap factor (i.e., (1+SpotYield)^-N). If the curve is for riskless bonds, the PV is for a risk free dollar. If be like that, as there are additional curve has been the curve is for, e.g., AA bonds, then the PV is for a dollar with that riskiness. considerations. For example, at the steepening slightly long end of the curve, the USD swap lately, suggesting that What else are spot curves useful for? They are the observed rates from which forward rates of rate is lower (the swap spread is The EUR swap rate is generally lower than the USD swap long term fixed interest can be calculated. Forward rates give insight into the future rates of interest that negative). Since the swap rate is paid rate, suggesting that payments at that fixed rate in EUR payments are being market participants expect. See the next section for more on this (up and to the right). in return for a floating rate, that are regarded as quite desirable. One possible reason, just seen as somewhat less suggests that market participants as an example, would be if the USD floating rate is valuable relative to expect the floating rate to be quite expected to track higher more than the EUR floating rate, floating rate payment low, or else that there is low liquidity making it more attractive (higher demand) to fix payments (i.e., so the market Questions or comments? Paul Laux, on the fixed pay side of the market at in EUR terms. requires larger fixed Department of Finance, [email protected] the long end (allowing fixed rate payments to make a fair payers to get a better deal). deal). Yields, Swaps, Next: Bloomberg Swap Manager &CorpFin Paul Laux Start with 5-year plain-vanilla . Teaching thoughts

Type SWPM to enter Bloomberg's "Swap Manager" facility. Pricing rooted in present values of Yield curves cash flows forecasted using OIS swap rates as the basis for discount rates and forecasting cash flows based on cash/futures interest rates and yield curves. Three screen regions (red boxes) show Swap pricing each counterparty (leg) details and market pricing. Swap Manager intro The value of fair value Corporate finance

More teaching thoughts

Zero premium indicates semiannual USD fixed coupon at 1.778% pa over 5 years is market- value-equivalent to quarterly USD LIBOR floating (recently at 0.263% pa) Yields, Swaps, Cross- basis swaps &CorpFin Paul Laux A basis for making cost of finance comparisons across Teaching thoughts

SWPM can also value cross-currency basis swaps (float-float swaps across Yield curves two currencies). Use PRODUCTS pull-down menu to chose this swap. Swap pricing Quarterly- reset quarterly-pay 5-year x-crncy across Swap Manager intro USD-EUR has zero premium for deal to receive USD LIBOR and The value of fair value pay EUR LIBOR minus a 23 b spread. Market conditions are Corporate finance USD LIBOR at 26.310 bp and EUR LIBOR at 22.6bp pa. More teaching thoughts Yields, Swaps, This is useful info...and not only for &CorpFin Paul Laux swap counterparties Teaching thoughts Yield curves

Swap pricing Usefulness: If I’m a treasurer with a Swap Manager intro • The value of fair value borrowing need, this analysis tells me what Corporate finance interest rate in someone else’s currency is a More teaching thoughts good deal in my currency Claim: Borrowing five years floating at semiannual• USD LIBOR is the same as cost of financing as borrowing five years floating at quarterly EUR LIBOR minus 23 bp Evidence for claim: One can be swapped into the• other, with zero premium paid/received...a zero NPV Yields, Swaps, Swap manager is flexible... &CorpFin Paul Laux ... to deal with various deals. Here is an annual pay swap. Teaching thoughts Use pull-downs to change reset and pay At annual reset and pay frequency, the -23 bp spread freq to "Annual". results in an "off-market" premium swap, with a Yield curves positive market value of 0.5955 bp, i.e. $5954 per $10 million of notional principal. Swap pricing Swap Manager intro The value of fair value Corporate finance

More teaching thoughts Yields, Swaps, The fair-value annual swap &CorpFin Paul Laux

Ask SWPM to calculate EUR LIBOR spread for zero premium. The at-market swap has a spread Teaching thoughts of -21.81 bp pa. Comparing to the quarterly EUR LIBOR case, increasing the rate paid to the EUR LIBOR leg a little reduces the PV of the deal to the USD LIBOR paying leg, so it is no Yield curves longer positive. Swap pricing Swap Manager intro The value of fair value Corporate finance

More teaching thoughts Yields, Swaps, Behind the scenes... &CorpFin Paul Laux Curves, cash flows, and valuation scenarios are on the SWPM tabs Teaching thoughts

Yield curves

Swap pricing Swap Manager intro The value of fair value Corporate finance

More teaching thoughts Yields, Swaps, BB help docs provide pricing and &CorpFin Paul Laux key-punch details Teaching thoughts ... green help key explains a lot of the finance I am skipping over Yield curves Swap pricing Swap Manager intro The value of fair value Corporate finance

More teaching thoughts Yields, Swaps, What’s it got to do with corp fin? &CorpFin Paul Laux If I’m a treasurer with a borrowing need, this analysis can tell us what interest rate in someone else’s currency is a good deal in my currency. Teaching thoughts Yield curves hhType XCF, for pictorial cross-currency basis swap premium analysis. Choose single currency analysis from Views pulldown, EUR (vs USD LIBOR) and 5 year term. Note results show spreads for a zero premium Swap pricing at various dates (including Today). Note this is bid view, i.e., the leg receives USD LIBOR. Corporate finance Benchmarking borrowing costs Application to fixed rate loans More teaching thoughts

Recall -23 bp is same spread we say with quarterly reset in earlier detailed analysis---numbers here are result of same analysis. Yields, Swaps, USD vs EUR LIBOR floating rates &CorpFin Paul Laux A lower EUR rate is PV-equivalent to a higher USD rate. Di↵erential level at 22-23 bp for maturities of 2+ years; was 45-ish bp last year. Teaching thoughts Yield curves Same analysis (XCF ), but now choose more maturities and mid-point quotes. We are moving toward a full comparison of financing opportunities in dollars and , from the point of view of a US based treasurer. The x-crncy basis swap market tells us what spread (EUR LIBOR differential Swap pricing vs USD LIBOR) would make for an at-market swap today---thereby telling us what would be an at- market deal comparison on floating rate loans. Corporate finance Benchmarking borrowing costs Application to fixed rate loans More teaching thoughts

Today's market, for various maturities

Today's market is the rightmost set of bars, with history to the left. Yields, Swaps, Can view info in various formats... &CorpFin Paul Laux ... to answer various questions; e.g., a yield curve view helps treasurer evaluate floating rate loan comparisons of various terms Teaching thoughts Yield curves

Swap pricing

Corporate finance Benchmarking borrowing costs Application to fixed rate loans More teaching thoughts Yields, Swaps, Analyze x-crncy fixed rates too &CorpFin Paul Laux ... by snapping on same-currency fixed-for-floating swap to each leg ... remember, swap manager prices those too Teaching thoughts Yield curves

Swap pricing

Corporate finance

Here is the USD side of the analysis. We have seen both these SWPM screens before. On left is a USD Benchmarking fixed-for-floating swap. On right is a USD-EUR LIBOR floating-floating swap (cross-currency basis borrowing costs swap). Application to fixed rate loans More teaching thoughts

1.78% fixed is PV-equivalent to USD LIBOR floating (i.e., with And USD LIBOR floating is PV-equivalent to EUR LIBOR - 23 timing details as shown). bp. So if treasurer with a 1.77% fixed USD borrowing opportunity can beat EUR LIBOR - 23 bp, it is a good deal (in PV terms; appropriate-for-the-use is a different question). To compare to a fixed rate EUR loan, snap a EUR fixed-for-floating swap onto this analysis. Yields, Swaps, Not a fantasy &CorpFin Paul Laux ... research has established that searching for good funding opportunities this way is profitable for AA-rated credits Teaching thoughts ... Journal of 86 (2007), 145-177 Yield curves Swap pricing

Corporate finance Benchmarking borrowing costs Application to fixed rate loans More teaching thoughts Yields, Swaps, Teaching tactics &CorpFin Paul Laux This sort of thing works best hands-on—but Teaching thoughts • Yield curves pound the points, as students will want to lose Swap pricing the forest for the trees Corporate finance More teaching My favorite routine: See one, do one, teach thoughts one• Force more than is comfortable: Detailed, graphical• briefing books; recordings; class lab exercises Better for depth than breadth; takes a lot of time• Yields, Swaps, The end. Thank you for your time &CorpFin Paul Laux and e↵ort! Teaching thoughts Yield curves

Swap pricing

Corporate finance

More teaching That’s all I know about Bloomberg and most thoughts of what I know about fixed income.

Questions?