2. Swaptions in LDI framework
Trustees concerned about un-hedged inflation and interest rate risk
Trustees could hedge inflation now, low by historical standards
Levels of nominal yields have remained low, less compelling to hedge
2
Hedging dilemma
Levels of yields
Don’t hedge
Affordability issue
Swaptions allows scheme to capture specific scenarios
Dilemma
Mismatch to liabilities
Hedge
Deflation risk
3. Trustee decision framework
Replace triggers with swaptions to lock in to higher rates
Add downside protection with swaptions to protect against pain of lower rates
3
Sell upside beyond triggers to fund downside protection
4. Hedging strategy for rates rising
Sell one or more payer swaptions with strike set to
coincide with scheme’s triggers
If rates rise beyond strike, scheme will be forced to
hedge at this level…a trade it would have
done anyway
Swaptions monetise this commitment, hence
compare favourably to triggers in almost
all scenarios
4
Nominal
interest rates
Scheme’s solvency
position
Sell upside beyond triggers Payer swaption
premium boosts
scheme returns
Payer expires
worthless,
premium collected
Payer caps rates
upside to solvency
Solvency position
without payer
5. Hedging strategy for rates falling
Selling payers monetises some of the upside benefit
from rate rises, however offers no downside
protection if rates fall
A scheme can buy protection against such falls in
nominal interest rates by buying receiver swaptions
The premium generated from payer sale could be
used to purchase receiver swaptions
5
Protect against fall in rates
Nominal
interest rates
Scheme’s solvency
position
Sell upside to
fund downside
Benefit from receiver
caps fall in solvency
Solvency position
without swaptions
Payer caps rates
upside to solvency
6. Zero premium collar
Buy £100m of 2y30y receiver at 2.64% for £3.9m (3.9% premium)
Sell £100m 2y30y payer at 3.64% for £3.9m (3.9% premium)
6
Payoff at expiry
Equidistant from ATMF of 3.14%
Sell payer at 3.64%
Buy receiver at 2.64%
Value
Interest rates
Trade structured to be premium neutral
Collar
Liabilities
7. Drivers of the swaption price
The value of a swaption can be separated
into two positive numbers: intrinsic value
+ time value
The intrinsic value is the value the option
would have if market conditions were left
unchanged up to expiry date
The time value is simply the difference
between the price of the swaption and its
intrinsic value, effectively capturing the
option value embedded in the
time-to-maturity
7
Factor Time value Intrinsic value
Rate -
Time decay -
Volatility -
Example: 4% Receiver swaption
Time value
Intrinsic
value
Interest Rates
3.0% 4.0% 5.0%
Swaption
Out-of-the-Money
Swaption
In-the-Money
8. Split expiry collar – time decay
As time passes, all else being equal swaption value (time value) declines
Time decay is slower initially but accelerates closer to expiry
8
2 Year time horizon
Time (years)
0 1 2 3 4 5
2 year option decays faster
5 year option 2 year option
10. Split expiry collar
Buy £200m 5y30y receiver at 2.98% for £13.5m (6.8% premium)
(Previously £100m of 2y30y receiver at 2.64%)
Sell £100m 2y30y payer at 3.64% for £3.9m (3.9% premium)
10
Buy cheap option, sell expensive option
Net premium is £9.6 million…
…but trade structured to be time decay neutral after 2 years
11. Spot (i.e upfront) premium swaptions
Spot premium received at inception
Counterparty requires collateral for
value of swaption
Premium returned as collateral
11
Payout on swaption at
expiry
Spot premium
received upfront
Value(%ofnotional)
-2.00
2.00
4.00
-4.00
0.00
Time
Swaption value = collateral (excludes premium)
12. Forward premium swaptions
Forward premium received at expiry
Net value at inception is 0
No collateral required at start
Now market standard between banks
Avoids collateral being locked up
12
Payout on swaption
at expiry
Forward premium
received at expiry
Value(%ofnotional)
-2.00
2.00
4.00
-4.00
0.00
Time
Swaption value = collateral (includes premium)
13. Strategy comparison after 2 years
13
Change in value after 2 years
(30)
(20)
(10)
-
10
20
30
40
-100 -50 0 50 100
Rates shift (bps)
Changeinvalue(£m)
Split expiry collar Zero cost collar Hedged liability
Split collar outperforms both
liabilities and ZC collar
Split collar retains its value
after 2 years
14. Implementation and considerations
Select proportion and size of swaptions hedge
Determine impact on scheme’s hedge
Examine how the swaptions could perform under different scenarios
Determine appropriate collateral requirements
Timing and execution approach
14
15. 15
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