Sunday, January 10, 2010

Structure Trade review

Structure Trade review – STR can be explained as a contract review process of structure & plain vanilla derivative trade contract.
In derivative contract trader enter into contract with interested party as intermediate and accept risk of change in market condition in order to hedge interested party exposer from change in interest rate or fluctuation in domestic or foreign currency, i.e. fixed income swap, interest rate swap, currency swap, credit default swap.

In order to further simplify, assume
Citi Bank enter into contract of interest rate swap with RIL and assuring that RIL have to pay only LIBOR + .07 for loan of notional amount of $1 Billion instead of MIBOR + 10% what RIL is getting from bank.
In order to executive and eliminate probability of miscommunication/misunderstanding, like in any other contract between two party there is a contract agreement, similarly in derivative contract there is a contractual agreement about
Terms of contracts
Basis of Payout calculation
Period of contract
Start date
Execution/due date
Individual party terms & condition in contract
And any other relevant terms
Finally like any other contract both party of derivative contract sign this contract and agreed with contract terms and condition.

Now STR
As the name suggest Structure Trade review of Derivative contract, member of STR team mainly see
Whether Economics of Trade have properly booked across the system (MO, BO, FO) or not, if not then communicating this to defaulting department rectify the same, if mistake not get corrected with the accepted time escalate issue to senior management/product controller.

STR have important role in derivative transaction since final payout is in millions or billions, if wrong doing is not identified within time company may lose billions of money.

Objective of STR team: to see all terms have accurately booked across the system so that payout flows according to agreed terms & condition.

Normally below are few most common steps in structure trade review
Step 1 – Payout understanding like A to B LIBOR + .05% + 12% - LIBOR + .15% = 12.1%.

Payout understanding is one of the most complicated tasks in any Structure Trade Review which consume more than 30% of total time of entire structure trade review process.
You should spend at least 30% to 50% of total time of STR, since this the area where we can save billions of our employer money & learn new thing about derivative market.

Step 2 – throughout study and understand rest of derivative contract which may impact on payout calculation.

Step 3 – we must have habit of in house discussion about each and every contract within the team which will help all team members to have better understanding/idea about what is happening outside.

Step 4 – Statically tick back across the MO and BO in order to insure entry in MO & BO is as per the terms.

Step 5 – Payout calculation at FO, this again one of the most important areas of entire structure trade review which takes almost 20% of total work since any mistake in this will direct reflect in final payout. This also common area of fraud for interested party since FO verification process is very complicated and any one can easily create smart money just by doing some smart manipulation in this area, hence as a STR team member it is our responsibility to have excellent understanding of FO verification process.

One of the most common tool that we use while calculating and verifying FO is “PC Tool”
We just need to enter all the economics terms in the PC tool and PC tool will automatically generate PL result that result must match with PL balance of Front office (FO), if not need escalation.

Step 6 – Write up and flow chart, during this process we need to capture payout by way of flow chart and all other measure observation in addition to routine work.

Step 7 – Follow up with BO, MO, FO, to rectify the mistakes within the reasonable time.

Step 8 - Escalation with PC if problem doesn't solve within reasonable time, ideally it is 15 Days.

Some of the important terms used in Derivative contracts.
Business Days – 5 Days in a week
Calendar Days - seven days in a week
Following days – if due date is on non working days payment will happen on next working days
Preceding days – if due date is on non working days payment will happen in immediately preceding working days
Modify & Modify following – if due date is on non working days and next working days is in next month then payment will happen on next following working days.Modify preceding – if due date is on non working days and next working days is on next month payment will happen in immediate preceding working days

If number of days in a year not specified in contract then as per ISDA (International Swap & Derivative Association) we will take 360 in a year

Few other days’ calculation terms
Actual/Actual means actual contract days/actual days in a year
Actual/360
Actual/365

Interest rate Swap

An interest rate swap is a derivative in which one party exchanges a stream of interest payments for another party's stream of cash flows. Interest rate swaps can be used by hedgers to manage their fixed or floating assets and liabilities. Unlike the bond interest rate swap does not includes principal amount

Interest rate swap can be of following type
Fixed-for-floating rate swap, same currency

For example, you pay fixed 5.32% monthly to receive USD 1M LIBOR monthly on a notional USD 1 million for 3 years.

Fixed-for-floating swaps in same currency are used to convert a fixed rate asset/liability to a floating rate asset/liability or vice versa. For example, if a company has a fixed rate USD 10 million loan at 5.3% paid monthly and a floating rate investment of USD 10 million that returns USD 1M Libor +25 bps monthly, it may enter into a fixed-for-floating swap. In this swap, the company would pay a floating rate of USD 1M Libor+25 bps and receive a 5.5% fixed rate, locking in 20bps profit.


Fixed-for-floating rate swap, different currencies


For example, you pay fixed 5.32% on the USD notional 10 million quarterly to receive JPY 3M (TIBOR) monthly on a JPY notional 1.2 billion (at an initial exchange rate of USD/JPY 120) for 3 years

Fixed-for-floating swaps in different currencies are used to convert a fixed rate asset/liability in one currency to a floating rate asset/liability in a different currency, or vice versa. For example, if a company has a fixed rate USD 10 million loan at 5.3% paid monthly and a floating rate investment of JPY 1.2 billion that returns JPY 1M Libor +50 bps monthly, and wants to lock in the profit in USD as they expect the JPY 1M Libor to go down or USDJPY to go up (JPY depreciate against USD), then they may enter into a Fixed-Floating swap in different currency where the company pays floating JPY 1M Libor+50 bps and receives 5.6% fixed rate, locking in 30bps profit against the interest rate and the fx exposure.

Floating-for-floating rate swap, same currency

For example, you pay JPY 1M LIBOR monthly to receive JPY 1M TIBOR monthly on a notional JPY 1 billion for 3 years.

Floating-for-floating rate swaps are used to hedge against or speculate on the spread between the two indexes widening or narrowing. For example, if a company has a floating rate loan at JPY 1M LIBOR and the company has an investment that returns JPY 1M TIBOR + 30 bps and currently the JPY 1M TIBOR = JPY 1M LIBOR + 10bps. At the moment, this company has a net profit of 40 bps. If the company thinks JPY 1M TIBOR is going to come down (relative to the LIBOR) or JPY 1M LIBOR is going to increase in the future (relative to the TIBOR) and wants to insulate from this risk, they can enter into a float-float swap in same currency where they pay, say, JPY TIBOR + 30 bps and receive JPY LIBOR + 35 bps. With this, they have effectively locked in a 35 bps profit instead of running with a current 40 bps gain and index risk. The 5 bps difference (w.r.t. the current rate difference) comes from the swap cost which includes the market expectations of the future rate difference between these two indices and the bid/offer spread which is the swap commission for the swap dealer.


Floating-for-floating rate swap, different currencies
For example, you pay floating USD 1M LIBOR on the USD notional 10 million quarterly to receive JPY 3M TIBOR monthly on a JPY notional 1.2 billion (at an initial exchange rate of USDJPY 120) for 4 years

To explain the use of this type of swap, consider a US company operating in Japan. To fund their Japanese growth, they need JPY 10 billion. The easiest option for the company is to issue debt in Japan. As the company might be new in the Japanese market without a well known reputation among the Japanese investors, this can be an expensive option. Added on top of this, the company might not have appropriate debt issuance program in Japan and they might lack sophisticated treasury operation in Japan. To overcome the above problems, it can issue USD debt and convert to JPY in the FX market. Although this option solves the first problem, it introduces two new risks to the company:


FX risk. If this USDJPY spot goes up at the maturity of the debt, then when the company converts the JPY to USD to pay back its matured debt, it receives less USD and suffers a loss.

USD and JPY interest rate risk. If the JPY rates come down, the return on the investment in Japan might go down and this introduces an interest rate risk component.

The first exposure in the above can be hedged using long dated FX forward contract but this introduces a new risk where the implied rate from the FX spot and the FX forward is a fixed rate but the JPY investment returns a floating rate. Although there are several alternatives to hedge both the exposures effectively without introducing new risks, the easiest and the most cost effective alternative would be to use a floating-for-floating swap in different currencies. In this, the company raises USD by issuing USD Debt and swaps it to JPY. It receives USD floating rate (so matching the interest payments on the USD Debt) and pays JPY floating rate matching the returns on the JPY investment.


Fixed-for-fixed rate swap, different currencies.
For example, you pay JPY 1.6% on a JPY notional of 1.2 billion and receive USD 5.36% on the USD equivalent notional of 10 million at an initial exchange rate of USDJPY 120.