Help with Base Rate SWAP Trade

Dear members

I would really appreciate some help with the folliwng problem.

I have some redundant base rate swaps which are just debiting around £6,000 each month, and it occured to me that I should be able to initiate an interest rate trade each month, to at least off set most of this cost, perhaps using options, swaptions, or options on futures. Although Ive been an active options trader for 14 years, interest rates arent my area. here are the details of the swaps.

Fixed rate base rate swap 5.78% GBP 357,232

Fixed rate base rate swap 5.77% GBP 923,808

So the total swap amount is £1,281,040

These swaps were originally for a 15 year term (early 2004), and now they only have 9 years left.

They were put in place back in 2004 to hedge a base rate loan, but then I paid the loan off and got lumbered with the swaps. Now they are just a liability debiting money from my account each month. Until base rate returns to more normal levels that’s going to continue for some time.

I should be able to trade against these swaps to earn some income and hedge off the risk. I wasn’t sure if I would be able to use the swaps to reduce margin, because they are held at a bank, not on my brokerage account. However, I suppose there’s a chance that I could supply trade confirmations to Interactive Brokers, who might then reduce my margin on the trade and thus make the trade more cost effective. As bank have a treasury management department I guess there is also a chance I could actually place the trades directly with them rather than Interactive brokers, but I know they won’t give me any advice about setting the trade up, and they may resist even taking a trade for me.

I use Interactive Brokers TWS trading platform, so I should be able to subscribe to whatever data feed I need for this trade, assuming I don’t have it already.

I could really use some guidance. Ideally help from someone who is has a good working knowledge of interest rate products, who can setup an initial trade for me, and explain the mechanics, so I can trade it going forward.

Jackal007

You're basically waiting for Martinghoul to read this ..

I am back...

Hold on, let me understand this correctly... You have these old base rate swaps you traded OTC with a bank to hedge an old loan. Now you have paid off the loan and you don't want the exposure, so you're looking for a way to get rid of this exposure by trading smth on IB? This course of action makes VERY little sense to me, for a whole variety of reasons. So, if I were you, I'd simply go to the bank and ask them to "unwind" the swaps (i.e. the trades are terminated/torn up/cancelled in exchange for a lump sum payment). It should be of marginal benefit to them (even though you're, effectively, lending them £1mm unsecured, they should be even more happy to reduce their exposure to your credit).

We waited all this time just for that? V disappointing, we were looking for something funky and exotic

Actually it reminds me of an interview I once had, many many years ago, where the senior trader asked me how I would hedge a smelly short dated exotic option. I was very new to the game but I was honest and told him that I would bite the bullet and unwind it in the market. That was actually the precise answer he was looking for, and I ended up getting the job.

Sorry to disappoint, but yeah, simple is often best, IMHO. I don't think it's extremely fair to ask questions like that in an interview, though.

I dunno, I thought it was a valid question, as part of the job entailed handling, well, smelly exotics.

I've seen so many instances of people trying to be "creative" with their hedging and it goes wrong more often than not. There was a classic case of a chap who covered a short Tokyo cut RKO by buying a NY cut RKO in the broker.. fine if you finish near the strike, but unfortunately spot was close to the barrier instead on the day of expiry, and you can guess what happened.

Sure, it's a valid (maybe even crucial) question to ask someone with experience, but I really don't think it's fair to try to ask trick questions like that of someone who's completely new to the biz and expects that the right answer is something altogether different.

And yes, there's lots of similar stories of "hedges" gone horribly wrong.

Martinghoul said:

I am back...

Hold on, let me understand this correctly... You have these old base rate swaps you traded OTC with a bank to hedge an old loan. Now you have paid off the loan and you don't want the exposure, so you're looking for a way to get rid of this exposure by trading smth on IB? This course of action makes VERY little sense to me, for a whole variety of reasons. So, if I were you, I'd simply go to the bank and ask them to "unwind" the swaps (i.e. the trades are terminated/torn up/cancelled in exchange for a lump sum payment). It should be of marginal benefit to them (even though you're, effectively, lending them £1mm unsecured, they should be even more happy to reduce their exposure to your credit).

Click to expand...

Unfortunately, if it were that easy I would have done it already. Cost to unwind £300,000! I think to setup a monthly interest rate trade makes much more sense, because you would balance the exposure. It doesn’t have to be perfectly symmetrical, because any move in rates generally will have an effect on the swap whether the actual base rate moves or not. This is similar in a way to using a base rate swap for a LIBOR loan. It’s not ideal, but it does provide somewhat of a hedge for the LIBOR loan. I simply need someone who fully understands the interest rate derivatives market who is willing to engineer a trade for me in the correct proportion and then walk me through it.
Jackal

jackal007 said:

Unfortunately, if it were that easy I would have done it already. Cost to unwind £300,000! I think to setup a monthly interest rate trade makes much more sense, because you would balance the exposure. It doesn’t have to be perfectly symmetrical, because any move in rates generally will have an effect on the swap whether the actual base rate moves or not. This is similar in a way to using a base rate swap for a LIBOR loan. It’s not ideal, but it does provide somewhat of a hedge for the LIBOR loan. I simply need someone who fully understands the interest rate derivatives market who is willing to engineer a trade for me in the correct proportion and then walk me through it.
Jackal

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I should also point out for those who think this was a customer’s creativity gone mad that all the major banks made these damn things compulsory for all large commercial loans, because they make money on them, more than if they provide the customer with a fixed rate loan. You can pay off a fixed rate loan much cheaper than you can break a swap, especially when base rates hit the floor. Some have sued their bank for the reckless abandon they shoved these things down people’s throats, and then walk away leaving the customer to pay the bill. I’m not happy about it, but I am trying to find a more proactive solution than being tied up in court for the next 2 years.

Makes sense and I am sorry for your predicament... The fact that they charge you this much is highway robbery. In this situation, I would agree that even an approximate hedge is better than the unwind.

I can help you to engineer smth and walk you through it, indeed. However, you have to realize that the ways to get rid of this exposure that will be available to you without unwinding the original positions are limited, to put it mildly.

Anyways, I assume you have recvd fixed, paid BOE base, at 5.77% and 5.78% on these two trades. You have given the two NPVs, correct? What are the notionals? What's the reset frequency on the floating side?

Martinghoul said:

Makes sense and I am sorry for your predicament... The fact that they charge you this much is highway robbery. In this situation, I would agree that even an approximate hedge is better than the unwind.

I can help you to engineer smth and walk you through it, indeed. However, you have to realize that the ways to get rid of this exposure that will be available to you without unwinding the original positions are limited, to put it mildly.

Anyways, I assume you have recvd fixed, paid BOE base, at 5.77% and 5.78% on these two trades. You have given the two NPVs, correct? What are the notionals? What's the reset frequency on the floating side?

Click to expand...

Hi Martinhoul

Here are the details of the two swaps.

I was thinking I could sell options each month of an equivalent amount. I can’t see that they would need to be anywhere near the actual rate of the swaps, because its all about any movement in the swap markets. So if I were to sell a bunch of options and the market moved up and I took a hit, then its far to say that the debit on the swaps will have reduced because the view on forward rates will have changed. Does that sound logical to you?

Fixed rate base rate swap 5.78% GBP 357,232

Fixed rate base rate swap 5.77% GBP 923,808

So the total swap amount is £1,281,040

These swaps were originally for a 15 year term (early 2004), and now they only have 9 years left.

Jackal

jackal007 said:

Hi Martinhoul

Here are the details of the two swaps.

I was thinking I could sell options each month of an equivalent amount. I can’t see that they would need to be anywhere near the actual rate of the swaps, because its all about any movement in the swap markets. So if I were to sell a bunch of options and the market moved up and I took a hit, then its far to say that the debit on the swaps will have reduced because the view on forward rates will have changed. Does that sound logical to you?

Fixed rate base rate swap 5.78% GBP 357,232

Fixed rate base rate swap 5.77% GBP 923,808

So the total swap amount is £1,281,040

These swaps were originally for a 15 year term (early 2004), and now they only have 9 years left.

Jackal

Click to expand...

It sounds somewhat logical, but the devil's in the details. What should be the underlying for the options you sell, what strikes etc. These are questions to be anwered, but before we get to that, there are more basic ones.

The 357,232 and 923,808 numbers, are they notionals, i.e. do you pay/recv 5.77% annually on 923,808 vs receiving/paying base rate? Are the base rate payments also annual? All this is needed to determine what your exposure to rates actually is...

Martinghoul said:

It sounds somewhat logical, but the devil's in the details. What should be the underlying for the options you sell, what strikes etc. These are questions to be anwered, but before we get to that, there are more basic ones.

The 357,232 and 923,808 numbers, are they notionals, i.e. do you pay/recv 5.77% annually on 923,808 vs receiving/paying base rate? Are the base rate payments also annual? All this is needed to determine what your exposure to rates actually is...

Click to expand...

The swap paymens are made monthly, and as I recall the amount reduces over the term so the balance now with 9 years remaining will be lower than it was over the original 15 year term. It reduces wth the loan balance. I can send an email request to the bank to provide an accurate figure for both swaps now, and I could also pose any other questions which you think are important to have answers for?

Jackal

jackal007 said:

The swap paymens are made monthly, and as I recall the amount reduces over the term so the balance now with 9 years remaining will be lower than it was over the original 15 year term. It reduces wth the loan balance. I can send an email request to the bank to provide an accurate figure for both swaps now, and I could also pose any other questions which you think are important to have answers for?

Jackal

Click to expand...

Aha, so it's an amortizing swap, with monthly resets... Did you receive or pay fixed? That's the most important aspect, really.

In general, yeah, it would be good for both of us to see the accurate description of all the trade details. They could make a difference.

jackal007 said:

I should also point out for those who think this was a customer’s creativity gone mad that all the major banks made these damn things compulsory for all large commercial loans, because they make money on them, more than if they provide the customer with a fixed rate loan. You can pay off a fixed rate loan much cheaper than you can break a swap, especially when base rates hit the floor. Some have sued their bank for the reckless abandon they shoved these things down people’s throats, and then walk away leaving the customer to pay the bill. I’m not happy about it, but I am trying to find a more proactive solution than being tied up in court for the next 2 years.

Click to expand...

I saw what the banks were doing that at the time with these swaps, esp in the commercial real estate markets, they sold on the fact that it protected the borrower by fixing their exposure. You are right though, it also made the banks money. They charged customersfor the swaps then traded them on. Conflicts of interest.

glyder said:

I saw what the banks were doing that at the time with these swaps, esp in the commercial real estate markets, they sold on the fact that it protected the borrower by fixing their exposure. You are right though, it also made the banks money. They charged customersfor the swaps then traded them on. Conflicts of interest.

Click to expand...

Well, the fact that they traded them with the customer and then hedged their exposure in the mkt isn't any sort of a conflict of interest. What is criminal is that they charge their customers a LOT to unwind these trades.

Martinghoul said:

Aha, so it's an amortizing swap, with monthly resets... Did you receive or pay fixed? That's the most important aspect, really.

In general, yeah, it would be good for both of us to see the accurate description of all the trade details. They could make a difference.

Click to expand...

I have all the documentation here which should have everything we need. As soon as Ive had a look through it Ill send yoiu what i have Friday. Anything that may be msising Ill request from RBS treasury, although their not very good at responding.

Thanks Jackal

Martinghoul said:

Well, the fact that they traded them with the customer and then hedged their exposure in the mkt isn't any sort of a conflict of interest. What is criminal is that they charge their customers a LOT to unwind these trades.

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Whats even worse is how they close ranks when they become a problem, and let the customer take the hit.

They claim they done nothing wrong, but then inthe same breath they refsue to provide any help or support, becasue that might imply there is something to fix.

Jackal

Martinghoul said:

Aha, so it's an amortizing swap, with monthly resets... Did you receive or pay fixed? That's the most important aspect, really.

In general, yeah, it would be good for both of us to see the accurate description of all the trade details. They could make a difference.

Click to expand...

Martinghoul

Ive attached the last two swap advices I have, and emailed a few queries to the bank. Ill get back to with those answers, assuming I ever received them of ocurse. The info atatched might be enough?

Jackal

Right, so these are both deals where you pay fixed and receive base. It's easy enough to hedge these, but the exact size of the hedge is hard to determine without knowing the details of the amortization schedule. Moreover, it's also difficult to tell the current PV of these two trades without knowing the amortization details. If the total fair value PV of the trades is close to what the bank wants to charge you for the unwind, you should just unwind them. So the only thing that remains to be determined is what happens to the principal amounts on these trades every time there's a payment.