This article appeared in The Edge Malaysia, Jan 30, 2011

Interest Rate Swaps – Post 2008 Crisis

In the previous article we discussed the trading of interest rate swaps as we knew it before
the credit crisis of 2008. This article will now examine how issues like uncertainty and
liquidity after the 2008 credit crisis introduced ‘basis risk’ into the market. We will also see
the emergence of the ‘basis swap’ to hedge this risk and how the interest rate derivative
market has changed as a result.

The uncertain environment

European finance is changing. Mounting debt, fear of sovereign defaults, instability of the
Euro and contrasting fiscal policies across the euro zone are causing anxiety to all market
players. Investors also expect regulators to reshape the market after the crisis and many
expect the actions to be too radical. Investors are pricing all these risks into bonds and
credit default swaps by demanding higher yields and premiums.

But the present environment also leaves the market in a position where it cannot see a clear
direction in short term interest rates and thus do not want to be exposed to interest rate
risk between 0 to 12 months. As a consequence, all finance trades are now being hedged for
interest rate risk as players are not willing to ride out a market move that goes against their
favour. In fact, there has been a surge in trading of interest rate swaps, futures as well as
options [source: www.fow.com].

Following this, brokers are noticing that beneath the surface, the character and the flow
dynamics of the market is changing. “One of the biggest changes in recent months has been
a shift from trading derivatives for the purposes of speculation, to trading becoming much
more of a hedging-related activity,” claims Don Smith, head of strategy and economics at
interdealer broker Icap in London. Corporations issuing fixed rate bonds and swapping to
floating rate, has become a much more important component of trading flow.

Proprietary derivatives trading desks of investment banks that used to be heavily involved in
speculating activities are being closed. Hedge funds activities have reduced significantly. A
research paper in April 2010, entitled European Derivatives 2010: The Buy-Side Perspective
on Equity Options, Futures and Swaps, also revealed that the biggest driver in trading
derivatives recently was hedging.

Liquidity in money markets have not returned

The prolonged situation of dried-up money markets since 2008 is now reshaping derivative
markets. In the U.S., traditional hedging vehicles like bonds and futures are being impaired
as they are not as liquid as they used to be. Net repayment of U.S. government debt has
affected the liquidity of the U.S. government bonds market. Shorting securities in the liquid
Treasuries market is no longer a viable method for the financial sector to hedge interest rate
risk in financial transactions. The Bank of International Settlements also noted that this
situation is encouraging market participants to switch to more effective hedging
instruments, such as interest rate swaps.

The underlying change in the characteristics of the interest rate derivative market is bringing
about a specific risk called ‘basis risk’.

The basis risk

Let us assume Bank A lends money to individuals at a variable rate that is tied to the London
Interbank Offer (LIBOR) rate but it borrows money based on the Overnight Indexed Swap
(OIS) rate. The difference between the borrowing and lending rates is called the spread or
the basis. Before the crisis, the spread was usually negligible. We can see this in Chart 1.

The OIS rate is based on the rates set by central banks who are accepted by the market as
‘risk-free’. The LIBOR curve represents lending rate by banks who were also viewed as ‘risk-
free’ before the crisis. Thus LIBOR moved in tandem with the OIS rates.

The credit-crunch changed the market’s perception, and banks are now more conservative
about default of other banks. These risks are being priced into the money market lending
rates. Chart 1 shows how the LIBOR and OIS spreads (difference between the LIBOR and OIS
rates) have increased after the crisis. The difference between the OIS and LIBOR rates shows
the additional interest charged for the credit risk of banks.

Chart 1: The LIBOR-OIS Spread

Source: The LIBOR-OIS Spread as a Summary Indicator, Monetary Trends, Nov 2008.

Previously many institutions held on to this risk as spreads were small and the perceived risk
was minimal. But after the crisis, basis spreads widened and banks are now managing their
basis positions more closely as spreads now have volatility, an exposure that needs to be
managed.

The basis swap to hedge basis risk

By entering into a basis rate swap like in Chart 2, Bank A in the above example exchanges
the OIS rate for the LIBOR rate and eliminates the basis risk. A basis swap is just a type of
interest rate swap where two parties swap floating (variable) interest rates based on
different money markets.

Chart 2- The basis swap example

Discounting Cash Flows – Pre crisis and Post Crisis

We discussed in the last article that to the price of a swap is the present value of its cash
flows. To obtain the present values, we just discount the cash flows with the appropriate
spot rates. For example, money to be received in 3 months time would be discounted using
the 3-month LIBOR rate, etc. It has been a practice for discount rates below a year to be
derived from the multiple yield curves in the money markets - like the LIBOR, OIS and plain
vanilla interest rate derivatives like swaps and futures for longer tenors (than a year).

Before the crisis, it did not matter much which yield curve was used because the rates
tended to move together as all curves were viewed as “risk-free”. After all, money market
players were always the central banks and large finance institutions. No one could imagine a
default in the money market by any of these banks. Post crisis, we know that this is no
longer true.

Given that banks are now perceived as risky, LIBOR and swap curves are not risk-free
anymore. As such, banks have to deal with the appropriate discount rates to use under
different circumstances. Some issues are discussed below:

Even 3-month LIBOR and 6-month LIBOR have considerable basis

Pre-crisis, the difference between a 3-month LIBOR and a 6-month LIBOR could be
explained purely by liquidity. But now, basis risk can exist between LIBOR rates in
different tenors. A bank that borrows on 3-month LIBOR and lends 6-month LIBOR may
 not want to leave the spread or basis un-hedged because there is a danger now that
those rates will not move in tandem. Why is this? The Deus Ex Macchiato blog explains:
“...you should not be able to make money by borrowing for 3-month and then another
3-month vs. lending for 6 or the other way around. But now when banks are taken as
risky parties, there is a difference between investing a Libor for 3-months and then for
another 3 and investing for 6: as in both trades, one is investing with different banks
who do not possess the same level of credit risk anymore”.

Such asymmetry reflects the different views of the market in different tenors, caused by
credit risk. For that reason, a basis swap which swaps the 3-month LIBOR with the 6-
month LIBOR may have had an almost zero price before but now is priced quite
significantly.

Many experimental models have been introduced lately to derive this “forward spot
basis” using liquidity and default modelling concepts.

Discount rates to reflect the rates earned by collateral posted by swap counterparties

These days, again due to credit risk, most interdealer swaps trades are collateralised at
least to some extent. More often than not, the collateral earns OIS. Thus when thinking
about replicating a swap’s cashflows, one is quite naturally drawn to the OIS curve for
discounting.

Funding rates used as discount rates

The assumption that a major swap market participant funded at LIBOR was manageable
in 2005 as LIBOR would not differ much from the true funding rate of the bank. But now
when clearly LIBOR is another risky rate – it matters which rate is used for discounting
for a particular security.

Conclusion

The basis swap spread has since come down but is not ignored now-a-days. It is taken as an
important parameter as it reflects the underlying funding needs of the general banking
community.

In just two years, the collective behaviour of the players in the money markets has
introduced a new risk, known as basis risk which brought on the basis swap. The change in
underlying characteristics of the market also led to a real issue in pricing of derivatives - in
constructing appropriate discount rates. These factors could not even have been imagined
before the crisis. Only time will tell what else may be cooking up under the blankets of the
markets going forward.