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De-Mystifying Derivatives

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De-Mystifying Derivatives For institutional investor use only Pacific Investment Management Company LLC, 650 Newport Center Drive, Newport Beach, CA 92660, 949.720.6000 CMR2017-1103-299224 1 Define common derivative instruments used to manage fixed income portfolios Discuss the risks associated with these instruments and how they compare and differ from cash bonds Describe how derivatives are used in an effort to efficiently manage a portfolio’s risk profile and generate excess returns 2 • It’s a contract whereby two parties agree to exchange cashflows or to enter into a type of transaction in the future • A financial instrument that derives its value from movements in an underlying security • Includes futures, options, swaps • It can provide greater flexibility in structuring portfolios and many managers use them – Modify portfolio risk characteristics – Security substitution – Potential for alpha generation – May improve portfolio liquidity • Potential to leverage the portfolio • Inadequate monitoring of derivatives’ effect on portfolio risk characteristics • Counterparty and basis risk Source: PIMCO Refer to Appendix for additional investment strategy and risk information. 3 Cash instruments Risks Derivative instruments Interest Rate Futures / Governments Swaps Interest rate Options Mortgages Credit Volatility Interest Rate Credit Corporates Credit Default Swaps (CDS) Default Sample for illustrative purposes only Refer to Appendix for additional risk information. 4 A futures contract is a highly standardized agreement to exchange cash for an asset at a future date. An obligation to buy or sell a certain asset at a certain price on a certain day. Long position Short position Clearinghouse $ $ Coordinates cashflows and Party A takes the other side of the Party B Asset trade Asset Applications for futures Substitution Hedging Managing duration and curve exposure Sample for illustrative purposes only. 5 Futures may be used as substitutes for physical Coupon Bond futures securities bonds May be attractively priced May have attractive risk characteristics Facilitate cash backing strategies Remaining cash available to be invested in higher-yielding short-term securities Buy Term premium Buy Amount cash-equivalent Credit premium bonds of cash securities Volatility premium directly investment Liquidity premium (98%) Initial margin (2%) Sample for illustrative purposes only. 6 Accounting leverage exists whenever Duration Range 8 years +/- 2 years gross assets are greater than net worth Non-levered portfolio Long futures 8 yrs Economic leverage exists whenever a portfolio’s expected risk exceeds that of Cash collateral 0.25 yrs a reference point or range Total duration 8.25 yrs Levered portfolio Long futures 8 yrs Long bond 8 yrs Total duration 16 yrs Hypothetical example for illustrative purposes only. Not intended to represent any particular PIMCO product, portfolio or strategy. 7 Current portfolio duration: 5.75 years; target portfolio duration: 4.75 years Instrument Duration Exposure Duration contribution German bund 8.00 years $50 M 4.00 years Mortgage bond 3.00 years $25 M 0.75 years Corporate bond 4.00 years $25 M 1.00 years Total $100 M 5.75 years Sell 10 year futures 8.00 years ($12.5 M) (1.00 year) New portfolio duration $100 M 4.75 years • Reasons for using the futures market: – Liquidity – Low transaction costs – Ability to target specific risk exposures Hypothetical example for illustrative purposes only 8 A swap is an agreement between two or more parties to exchange cash flows over a set period of time “A” receives (buys) fixed-rate of 5% 5% Party A Party B “receiver” “payer” LIBOR (floating) Applications for swaps “A” pays (sells) floating- Substitution rate Hedging Managing duration and curve exposure Sample for illustrative purposes only. 9 An over-the-counter agreement between two parties to exchange the CDS cashflows before maturity/default credit risk of an issuer or basket of PIMCO Protection on default Counterparty issuers Sells Protection Buys At inception no money changes hands Quarterly premium Protection Protection seller: • Assumes credit risk • Receives payments expressed as spread over LIBOR • Agrees to purchase underlying bond at par in event of default High grade CDS-bond basis 50 Protection Buyer: 0 • Pays a premium to the seller for the right to sell the underlying bond at par when there is a credit event as -50 defined in the agreement Buyer is protected against credit events (default, -100 bankruptcy, etc.) -150 • Buy Protection = “Short Credit” points Basis -200 Sell Protection: Receives a premium from the buyer and must buy the bond at par in the case of a -250 credit event -300 • Sell Protection = “Long Credit” May '05 May '07 May '09 May '11 May '13 May '15 May '17 As of 31 May 2017; Source: PIMCO Sample for illustrative purposes only. 10 Definition: The right (but not the obligation) to buy or sell an asset at a set price by (or at) at specific time • Call option: The right to purchase the underlying asset • Put option: The right to sell the underlying asset Applications Hedge (long options) • Long put options may protect a portfolio from falling asset prices • Buying call options may allow a portfolio to benefit from rising asset prices As a substitute for physical security To add yield (written options) SOURCE: Frank Fabozzi Refer to Appendix for additional investment strategy and risk information. 11 Bond investors are paid to assume risk. The five primary risks in a bond portfolio are: • Interest rate risk • Volatility risk • Credit risk • Default risk • Liquidity risk These risks are present in both cash bond and derivative instruments Derivatives give investors great flexibility to manage risk but must be used responsibly The goal of fixed income investing is not to avoid risk, but to understand and be compensated for risk taken Refer to Appendix for additional risk information. 12 LONG FUTURES BUY NOTE Action Cash flow Action Cash flow Cash balance $100.00 Cash balance $100.00 Invest at money market $1.00 Buy bond ($100.00) rate 100 x (4.00% ÷ 4) Accrued coupon Pay futures liability $(99.50) $1.50 100 x (6% ÷ 4) = spot ($100) + interest ($1) – coupon ($1.50) Future Value of $100.00 Future Value of bond $100.00 bond Total $101.50 Total $101.50 Return 1.50% Return 1.50% Hypothetical example for illustrative purposes only 14 One 10-year note or futures Two 5-year futures 8 year duration Yield 8 year duration 3 Mos 5 Yr 10 Yr 30 Yr Maturity SOURCE: PIMCO Sample for illustrative purposes only. 15 Example: Eurodollar futures Eurodollar rate: Interest rate earned on dollar denominated assets held outside of the U.S. Contract indexed to 3-month London Interbank Offered Rate (LIBOR) Duration is three months (0.25 Years) Exchange traded, very liquid, settled in cash Contract Size Duration Change in Rates Dollar Impact $1,000,000 0.25 years 0.01 % $25.00 Sample for illustrative purposes only. 16 1 Year 3-month 3-month 3-month 3-month Yield Mar Jun Sep Dec Mar 1-year exposure can be achieved in different ways: Instrument Par/Notional Duration Total Duration 1-Year LIBOR $1,000,000 1.00 Year 1 Year Eurodollar Future $4,000,000 0.25 Year 1 Year SOURCE: PIMCO Sample for illustrative purposes only. 17 • Swaps are highly liquid and have built-in forward rate expectations as well as a credit component, therefore the swap rate curve has become an important interest-rate Why are swaps important? benchmark for credit markets that in some cases has supplanted the U.S. Treasury yield curve • The first swap was a currency swap involving the World Bank and IBM in 1980 • The first interest rate swap was an agreement in which Sallie Mae swapped interest When were swaps created? payments on fixed-rate debt for floating-rate payments indexed to the 3-month Treasury bill yield • Initially, interest rate swaps helped corporations manage their floating-rate debt liabilities How did the interest rate • Later, swaps became an attractive tool for other fixed-income market participants, swap market develop? including speculators, investors and banks because they reflect the market’s expectations for interest rates in the future • Investment and commercial banks with strong credit ratings are swap market-makers, offering both fixed and floating-rate cash flows to their clients Who utilizes interest rate swaps? • The counterparties in a typical swap transaction are a corporation, a bank or an investor on one side (the bank client) and an investment or commercial bank on the other side • Vanilla swaps, which involve the exchange of floating-rate LIBOR for a fixed interest rate What is the most common type of swap? SOURCE: PIMCO. While the Dodd-Frank Wall Street Reform and Consumer Protection Act represents sweeping reform, PIMCO does not see any significant impediments to our ability to use derivatives to add value to client portfolios. However, as the Dodd-Frank legislation provides mostly a framework, many of the details are being determined in the regulatory rulemaking process, which is on-going. 18 The protection seller assumes credit risk (like buying a bond) Protection seller agrees to receive a quarterly series of payments (expressed as a spread over LIBOR) in exchange for the protection buyer’s right to give the seller the underlying issuer’s bond and be paid par in the event of default Protection on default CDS cashflows before Counterparty PIMCO maturity/default Buys Sells Protection Quarterly premium Protection Par Physical settlement in PIMCO case of default Counterparty Sells Protection Delivery Obligation Cash settlement in case PIMCO of default Par-Recovery Value Counterparty Sells Protection Sample for illustrative purposes only. 19 Call option • Buyer of a call option pays a premium • As the value of the asset increases, buyer of a call benefits Profit Profit • Bull market strategy 0 Loss (premium) Put option • Buyer of a put option pays a premium Loss • As the value of the asset decreases, buyer of a put benefits 0 Strike • Bear market strategy Price of Asset Profit Profit 0 Loss (premium) Loss SOURCE: Frank Fabozzi 0 Strike Sample for illustrative purposes only.
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