Implementing LDI with swaptions - Russell Investments

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STRATEGY TIMING IMPLEMENTATION INVESTMENT FOCUS Implementing LDI with swaptions By: Lisa Cavallari, Director, Fixed Income Derivatives, and Martin Jaugietis, CFA, Head of LDI Solutions Lisa Cavallari Martin Jaugietis 1 For more details of the swaption market, see Tom Fletcher (2011), “Conditional interest rate trades when the yield curve is steep: development of the case for swaption use,” Russell Investments. With the increased adoption of liability-driven investing (LDI) by corporate defined benefit (DB) pension plans, the range of instruments available to help implement LDI programs has widened. One of these instruments is an option on interest rate swaps, generally referred to as a “swaption,” which can fit especially well into a program designed to reduce risk in accordance with a liability-responsive asset allocation (LRAA) schedule. Available instruments for implementation of an LDI program include Treasury bonds; corporate and other non-government bonds; exchange-traded derivatives, such as interest rate futures and options; and over-the-counter (OTC) instruments, such as swaps and options on swaps. It is the OTC market and, in particular, options on interest rate swaps (“swaptions”) that we will examine in this article. What is a swaption? An interest rate swap is, as the name suggests, an exchange of one interest rate for another. For example, one investor might agree to pay another a fixed rate for 10 years (the fixed rate being determined by the current market level of interest rates) and in return receive a floating rate (the floating rate being determined by a market rate such as the London Interbank Offer Rate, or LIBOR). The effect is similar to that of an investor’s selling a 10-year bond and holding cash. Because the terms of the swap are based on current market rates, no money needs to change hands at the outset; the value of the obligation to pay one interest rate and the right to receive the other are equal at the outset, although that will change once the terms are established and as market prices then move over time. A swaption is an option to enter into a swap trade. 1 A “3y10y” swaption is the right to enter into a 10-year swap trade in three years, based on terms that are set today. An example: suppose you buy a receiver swaption, i.e., an option to receive a fixed rate and pay a floating rate for 10 years starting in three years. Fast-forward three years: if the terms that are available on the 10-year swap at that time are better than those in the swaption, then you will not exercise the option. If the terms in the swaption are better, then you will exercise it. As with all options, you are in a good position if you are the holder of the option; if you like the deal at the exercise date, you win—if you don’t like the deal, you don’t lose. And, as with all options, that good position comes at a price: a premium has to be paid at the outset to buy the option. Swaptions and LRAA What makes swaptions intriguing in an LDI context is their conditionality, as well as their potential interaction with an LRAA schedule. Russell Investments // Russell Communiqué p / 4
RUSSELL INVESTMENTS In today’s low interest rate environment, many plan sponsors have been reluctant to fully eliminate the interest rate risk in their plans but have preferred a more incremental approach to LDI. In this sense, one application of LRAA is to increase the duration of a plan’s fixed income investments incrementally as the allocation to fixed income increases overall. 2 While this approach has some merit, the unfortunate outcome for most plans in the very early stages of their LRAA and/or LDI programs has been that they remain in very shortduration positions vis-à-vis liabilities, and funding levels have suffered in the recent declining interest rate environment. The ultimate goal in an LDI portfolio is to increase the duration exposure of fixed income investments, and we know that plan sponsors want protection against declining interest rates. One version of a swaption trade—the “zero-cost collar,” discussed below—provides this type of exposure by offering protection against declining interest rates in exchange for the promise to enter a swap at a certain interest rate above current rates. While there are many moving parts in this version, these higher rates can potentially be aligned at levels along the LRAA schedule, where the plan sponsor would be increasing the duration exposure of the fixed income portfolio in any case. An example of a swaption trade: the zero-cost collar The swaption trade we describe below is based on buying a receiver swaption at a low interest rate (to offer the protection we’d like to have, should rates fall) matched by selling a payer swaption 3 at a higher rate (the rate at which we are likely to be seeking longer-duration exposure anyway). For convenience, the terms of the two deals can be chosen such that the premium paid for buying the protection of the receiver swaption is equal to the premium collected for selling the payer swaption. Exhibit 1: Rates Swap curve date 8/30/2011 10y (spot) 2.36 3y10y (forward) 3.41 Source: Bloomberg Exhibit 2: Strategies Strategy Zero-cost swaption collar Payer strike Receiver strike A 3y10y+50 3.91 3.04 B 3y10y+100 4.41 2.70 C 3y10y+150 4.91 2.38 D 3y10y+200 5.41 2.10 Source: Bloomberg The interest rates associated with such a trade, as of August 30, 2011, are shown in Exhibit 1. At that date, the at-themoney-forward (ATMF) rate was 3.41% 4 . In Exhibit 2, the payer swaption strikes at 50-basis-points-higher increments are 3.91%, 4.41%, 4.91% and 5.41%. The strike shown for the receiver swaption is in each case the strike that results in an equal premium for the two swaptions (i.e. creating a zero-cost collar). In Exhibit 3, we illustrate the effect of these strategies by looking at the impact of interest rate shock at option expiration on an example plan that is 80% funded. The first thing we note is that all of the swaption strategies reduce the impact of interest rate variation on the funded status of the plan. This should not be a surprise: in each example strategy there is a built-in exposure to interest rates, so it becomes a de-risking strategy for any DB plan whose liabilities are driven by interest rates. 2 For a description of this strategy, see Jim Gannon & Bob Collie (2009), “Liability-Responsive Asset Allocation,” Russell Viewpoint. 3 A payer swaption being the right to pay the fixed rate and receive the floating. 4 This can be thought of as the 10-year swap rate which current pricing implies the market expects in three years’ time. p / 5
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Implementing LDI with swaptions - Russell Investments

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