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Building CSFB's Master E-Plan
Ed Condon, director at Credit Suisse First Boston, explains how his firm has embraced e-commerce, and the challenges it faced along the way.
Less than five years ago, I stood in an open-outcry pit in London with a stack of trade tickets. You can't get any more low-tech than that. Now I run e-commerce marketing for Credit Suisse First Boston in Europe. If I can learn the ins and outs of the Internet, anybody can.
At CSFB, when we first started looking seriously at the Internet as a means of doing business, we were struck by its potential. We believed it would enhance and possibly transform our customer interface, increase our productivity and improve service to new and existing clients. It would also allow us to make external investments and develop alliances to create strategic value for our company, capture big financial returns and, since we were early players, help us to guide the industry's development—all with the goal, naturally, of improving CSFB's industry standing and bottom line. And we wanted to do that across all three major areas of our investment bank—sales and trading, issuance and research.
In sales and trading, we never believed e-commerce would completely eliminate the role of intermediaries. People will always be incredibly important in the sales and trading functions. We sought to develop a strategy that would complement the people we had, rather than eliminate them. Because people play a vital role in fixed-income trading in particular, the evolution toward electronic trading in this arena is far slower than it is in equities or foreign exchange. But the transition is underway.
We expect significant margin pressures to occur in fixed income as electronic trading takes hold of the market. This will give large dealers like CSFB and others an opportunity to influence the outcome, because electronic trading directly between customers is likely to remain limited, at least in the near term. Dealer-to-dealer systems will almost certainly come first.
But client systems like PrimeTrade, our Internet-based transaction system for listed derivatives and foreign exchange, are advancing rapidly. We view the Internet as an opportunity to provide a unique window through which to execute transactions, either on a one-to-one or combined basis. It will reduce transaction costs for clients and brokers, and will unify and simplify access to different exchanges and over-the-counter market-making efforts.
| In fixed income, many people spend three-quarters of their time transacting only about one-quarter of their revenue business. |
How will we get to where we want to be? Our overall strategy at CSFB has been to apply Internet technology to every line of business we're involved in. We view this as a thousand flowers blooming at once. At some point, we plan to bundle those flowers together into a bouquet.
Fast, error-free straight-through processing will become the centerpiece—and will be a competitive necessity. Why? Internal desks and customers will demand links to an increasing number of exchanges to access liquidity pools. They'll also seek price information aggregated from numerous sources to increase efficiency. In terms of pricing systems, there'll be a need for automatic quoting systems—and that will require more sophisticated models. Also, fast price-generation and delivery will be critically important.
That's a long list of innovations. But once completed, they'll combine to fundamentally change the role of traders and salespeople, allowing them to focus more on value-added activities. For salespeople, calling customers to advise them on all manner of opportunities will be replaced with a new focus on high-value-added sales, since customers will be able to use the on-line system for more commoditized products. Since the electronic platform will be able to disseminate reams of research to customers, salespeople won't have to be responsible for that. Instead, they'll be able to focus on specialized advice. And writing tickets for transactions won't be necessary anymore, allowing sales staff to focus on more value-added activities.
The trading desk will be fundamentally changed as well. Instead of negotiating trades of all ticket sizes with customers, the electronic platform will automatically price smaller trades, thereby freeing up time for other activities. Traders won't be bogged down with analyzing key performance metrics manually; the electronic platform will handle that function, providing the information to traders on demand. The electronic platform will also supplement the trader's knowledge by providing on-line market behavior information from all relevant desks—vastly improving the trader's knowledge base.
The result of these innovations: more efficient traders and salespeople. In fixed income, many people spend three-quarters of their time transacting only about one-quarter of their revenue business. That means they spend a lot of their time doing repetitive work, like checking prices they never trade on. We believe that in using electronic systems, we can make all of our salespeople and traders more proactive, more creative and more efficient.
Of course, getting there won't be easy. There are four main challenges in developing a derivatives electronic trading system: establishing a secure trading environment; establishing clear benefits of straight-through processing; providing true value-added services to customer base; and mastering the compliance, regulatory and legal operating framework.
Security is not perfect in the electronic world. The real questions: Is it more risky than transacting business in the traditional way? And when is a security risk acceptable? We need to protect the confidentiality of our customer data and we need to prohibit access to predatory intruders. Unfortunately, that will probably mean a trade-off between security and speed—particularly as we adapt to each customer's needs.
| There can be delays on an intranet as well, and it can be tough to manage, since all intranet providers are not equal and customer service can vary widely. |
We've decided to offer a choice to our customers of the Internet or an intranet. The Internet is readily available, and with common access methods everywhere. But response time could be a problem on a high-volume usage day. The intranet solution offers guaranteed speed and a high level of security and integrity. But there can be delays on an intranet as well, and it can be tough to manage, since all intranet providers are not equal and customer service can vary widely. No matter which delivery system a customer chooses, we must be sure to protect the communication channel as well as possible, using either SSL for the Internet or various types of hardware for the intranet solution.
STP is probably the biggest challenge. Right now, even the most vanilla products—listed futures and options—present tremendous STP obstacles for our PrimeTrade product. Connections to the exchanges are still usually terminal-based, and the back-end connections are usually weaker, slower and less sophisticated than the execution platform connections. We need to interface the exchange execution system, the exchange clearing systems, the exchange risk management system, the main back-office system, the customer back-office system, the traders' front- and back-office systems, the bank cash management and collateral system, the credit systems, and the regulatory reporting systems. We have our work cut out for us, to put it mildly.
The value-added challenge is also a difficult one. Our goals are ambitious: we want to provide better information and trading strategies, centralize market sentiment via chat and research facilities, and allow customers to be able to cancel all orders at once. In order to do all this, we will have to offer real-time positioning, margining and clearing data, and analytics such as news, market research, quantitative research and an array of sophisticated calculators. Clearly, that's no easy task.
Finally, in terms of the regulatory hurdles, we need to manage the conflicting mess that is international derivatives regulation. In the United States alone, there are 13 regulators. Imagine what this implies when considering the 52 futures exchanges around the world. And since the Internet is clearly a global phenomenon, the challenges are that much more apparent. A trading system must maintain the offshore vs. onshore distinction while still guaranteeing customer margin protection, custody responsibilities and so on.
Mastering the Internet to create a workable derivatives trading system isn't an easy task. But it's critically important. If you don't do it, someone else will. And soon.
Edward Condon, a director at CSFB, is responsible for European listed derivatives and e-commerce marketing. CSFB's PrimeTrade is part of a family of products that includes PrimeVision (research), PrimeDebt (new issuance) and PrimeClear (clearing and settlement data).
The Mortgage-Industry Tinderbox
Doug Noland, financial market strategist at Tice & Co., argues that the explosive growth of mortgage debt and interest rate derivatives has seriously destabilized the global economy—and that one market disturbance could spark disaster.
Many people think the Federal Reserve has finally engineered the economic soft landing everyone's been expecting. I disagree. Complacency in the fixed-income markets is unwarranted—and could be disastrous.
It's ironic that market sentiment has turned so bullish just as key developments at home and abroad threaten economic stability. In the United States, a fragile financial sector and a distorted, unbalanced economy are the byproducts of years of rampant financial excess. At the same time, the global economic environment has become far less benign. A decade-long period of general price stability now appears to be giving way to an inflationary bias. Such developments have heightened the risk of a nasty surprise in the interest rate market.
There's a hidden, yet far more threatening, danger as well: key structural flaws in the massive interest rate derivatives market that could prove devastating should a significant market disruption occur. Simply put, the highly over-leveraged U.S. financial sector—with its tens of trillions of dollars of notional derivatives contracts—is hardly better able to insure against a financial shock than the Russian banking system was in 1998.
Much has been written on the risks and weaknesses associated with derivatives. Not nearly enough attention has been paid to the effects of over-the-counter derivatives activities on available aggregate credit—a subject the International Monetary Fund discussed in a recent report. The proliferation of derivatives is part of a historic period of money and credit excess—particularly in mortgage finance. This has profound ramifications for the stability of the U.S. financial sector and the soundness of the economy as a whole.
Admittedly, despite a few disturbingly close calls, the derivatives marketplace has performed swimmingly throughout this protracted U.S. boom—which explains the current complacency. But consider an analogy: the proliferation of interest rate swaps and derivatives over the past five years is much like the explosion of flood insurance underwriting during a long drought. Since extending flood protection with scarce rainfall is hugely profitable, policy providers pop up everywhere, driving down prices. Speculators are also enticed into the business, writing policies with the expectation of reinsuring in the event of a major downpour. And inexpensive and easily available flood protection hastens a wonderful building boom along the river, resulting in general prosperity throughout the community.
But when the inevitable flood occurs, the costs of the insurance boom-turned-bust will be apparent. The consequences: tremendous damages sustained by the new community that evolved along the water, and a flood insurance industry without the wherewithal to settle claims.
Wretched excess
During the past 10 quarters, total mortgage debt has increased an astonishing $1.5 trillion—some 28 percent of gross domestic product. Despite the perception of a meaningful housing slowdown, total mortgage debt expanded at a record annualized rate of $687 billion (11 percent) during the second quarter. By comparison, mortgage debt increased by $179 billion during 1994, and $202 billion in 1995. Government-sponsored enterprises (GSEs) such as Fannie Mae, Freddie Mac and the Federal Home Loan Bank System expanded their holdings at a 13 percent annualized rate during the second quarter, a significant increase from the first quarter's 7 percent increase—and there is evidence that aggressive lending practices continue.
| Key structural flaws in the massive interest rate derivatives market could prove devastating should a significant market disruption occur. |
On top of this explosion of mortgage debt, the United States has been in the midst of an unprecedented expansion of money and credit. Since 1995, total outstanding U.S. credit market debt has increased by $9.3 trillion, or 54 percent, to an incredible $26.5 trillion. Total financial-sector borrowings, meanwhile, jumped by $4.1 trillion to almost $8 trillion, while the broad money supply increased $2.5 trillion, or 58 percent.
Much of this astonishing growth came from outside traditional banking channels, with the capital markets and non-bank lenders playing an increasingly significant role in the credit-creation process.
Looking over the history of the U.S. financial system, it's not an exaggeration to label the 1990s the decade of the GSE. At the beginning of the decade, outstanding agency securities totaled $1.3 trillion; by the turn of the millennium, that figure had ballooned to $3.9 trillion. In the last five years, outstanding agency securities have increased $1.9 trillion, or 85 percent, while total mortgage debt expanded $2.3 trillion, or 52 percent.
While the issuance of mortgage-backed securities accounts for a considerable portion of new agency securities, further debt issuance has been required to finance ballooning balance sheets, particularly by Fannie Mae, Freddie Mac and the Federal Home Loan Bank System. These powerful institutions ended this year's second quarter with total assets of $1.64 trillion—including enormous off-balance sheet exposure—supported by equity of approximately $61 billion. Total assets have mushroomed by more than $1 trillion since 1995 (166 percent), with growth of $707 billion during just the past 10 quarters. All three institutions have relied extensively on short-term borrowing to finance their rapidly expanding mortgage portfolios, ending 1999 with more than $660 billion of short-term debt.
The derivatives flood
Managing the risk of volatile and often-unpredictable mortgage paper is, of course, a challenging proposition. Relying on short-term financing—apparently in a quest to maximize profits—makes things even more difficult. GSEs have turned aggressively to derivatives, becoming major players in the interest rate derivatives marketplace. In fact, the big three GSEs ended 1999 with more than $1 trillion notional in derivatives contracts, of which about $600 billion were interest rate swaps. The Federal Home Loan Bank System has swap positions surpassing $320 billion. Freddie Mac ended 1999 with $268 billion notional of futures and options. Needless to say, those are enormous positions.
While credit and GSE debt were exploding, so, too, were interest rate derivatives positions at U.S. commercial banks, which have surged $21.5 trillion since 1995 and now sit at $31.4 trillion. The seven largest U.S. commercial banks hold $37.4 trillion of total derivatives, of which $20.2 trillion are interest rate swaps. Chase, with a stock market capitalization of $25.4 billion, has total notional derivatives positions of $14.3 trillion, including $8.7 trillion in swaps. JP Morgan, Bank of America and Citibank are similarly leveraged.
Risky business
Nowadays, from Wall Street to the Federal Reserve, there is wide acceptance of the seductive notion that derivatives reduce risk by providing a mechanism to unbundle, differentiate, transform, allocate and shift market exposures, and that derivatives enhance the market mechanisms for pricing and resource allocation. This is a dangerous fallacy. Since the vast majority of derivatives are written by the financial sector, it is, paradoxically, precisely the parties most acutely vulnerable to financial turbulence that have become the repositories for the enormous expansion of risk associated with the continuing credit and economic boom.
| The highly over-leveraged u.s. financial sector is hardly better able to insure against a financial shock than the russian banking system was in 1998. |
The dynamic hedging strategies used by sellers of interest rate and other financial-market insurance exacerbates financial instability. The self-reinforcing nature of dynamic hedging virtually ensures episodes of abrupt illiquidity and general market disruption and dislocation. That this fact was not learned from the 1987 stock market crash, the credit market disruptions in 1994, the Mexican collapse in 1995, the collapse of Southeast Asian currencies in 1997, the Russian and Long-Term Capital Management debacles in 1998, the gold market dislocation in September 1999, and other periods of acute stress in the U.S. credit and currency markets is utterly amazing.
While cancerous financial risks have been allowed to grow for years, a strong case can be made that years of money and credit excess are finally coming home to roost. Indeed, a series of festering ills—a highly leveraged financial sector, unfolding credit problems, historically high asset inflation, a consumer borrowing and consumption binge, unprecedented trade deficits, and severe economic distortions and imbalances—all boil down to manifestations of credit excess.
These factors combine to create a dangerously fragile global financial system. This is no time for complacency, particularly as a global energy crisis unfolds and global currency markets show noted turbulence. I can't imagine a time when the financial sector has been more vulnerable to higher interest rates or other economic disruptions.
And the behemoth mortgage finance industry, with bloated balance sheets, massive short-term borrowings, immense derivatives positions and, at the same time, great exposure to credit losses when the housing bubble bursts, is in the eye of the storm.
The "Good Banker/Bad Banker” Exercise
Keith Brown and Donald Smith challenge readers to recommend the correct risk management strategy for a corporate customer. Can you choose the "right” answer?
Devising a derivatives strategy begins with identifying a problem that needs to be resolved. Once the problem is understood, the solution is largely a matter of technical detail. For instance, how many futures contracts should be bought or sold and for what delivery dates? At what strike prices and for which expiration dates should options contracts be purchased or written? Should the requisite derivatives be traded on an exchange to minimize counterparty credit risk or in the over-the-counter market to minimize basis, or tracking, risk? Getting these details right only matters if the underlying problem has been correctly identified in the first place.
The exercise developed here involves a bank relationship officer who is asked to recommend a derivatives strategy for a corporate customer. I call it the "Good Banker/Bad Banker” exercise, because there definitely is a right answer and a wrong answer to the problem. After you read the facts of the case, play along by reading the product overviews and making a recommendation. Later, you'll find out if you are a "Good Banker” or a "Bad Banker.”
The case scenario
Suppose that a corporation issued an 8 percent, $100 million, seven-year callable bond two years ago. The bond is callable at par value in exactly two years. Therefore, it currently is still in the call protection period. Market rates have fallen since the bond was issued, but the corporate treasurer's strongly held view is that interest rates have bottomed and will rise over the next few years. Note that the relevant time period here is the 2 x 5 forward period. Therefore, the key interest rate is a 2 x 5 forward rate—the corporation's three-year cost of funds that prevails two years into the future. See the time line in Figure 1.
The corporate treasurer's main concern is that market interest rates will rise enough prior to the call date, making the call option worthless. The essence of the risk management problem is that the call option is embedded in the bond. If it were currently exercisable, the treasurer would call the bonds and refinance now to capture the option's intrinsic value. If it were detachable, the treasurer would sell the option now to capture its intrinsic, as well as its time, value. Neither of those alternatives is possible, however. The treasurer, expecting higher rates, fears that the call option will expire out-of-the-money and the higher coupon rate paid for the option will not have generated any financial benefit.
A commercial bank relationship officer who covers the corporation is asked by the treasurer for ideas using OTC derivatives to deal with the problem. Which one of the following two strategies using interest rate swaptions should the banker recommend to the corporate treasurer? Why?
- The corporation buys a payer swaption. The corporation acquires the right to enter a three-year swap in two years as the fixed-rate payer at a strike rate of 7.5 percent. The payer swaption will cost the corporation $1.2 million. The premium is to be paid upfront.
- The corporation writes a receiver swaption. The counterparty has the right to enter a three-year swap in two years as the receiver of a fixed rate of 7.5 percent. The corporation becomes the fixed-rate payer if the swaption is exercised. The corporation will receive the premium of $3.5 million upfront.
The floating rate on the interest rate swap is six-month Libor, net cash settlements will be on semiannual basis, and the notional principal matches the $100 million par value on the callable bond.
Currently, the fixed rate on a 2 x 5, at-market forward interest rate swap is 6.5 percent. Therefore, the 7.5 percent payer swaption is an out-of-the-money contract, while the 7.5 percent receiver swaption is in-the-money. That explains why the dollar premium on the receiver swaption is higher than it is on the payer swaption. You should assume that these are fairly priced options. That means your choice of derivatives strategy should not depend on the amount of the premiums.
Notice that the payoff on the embedded call option depends on the corporation's future cost of funds vis-à-vis 8 percent, whereas the payoff on either of the swaptions depends on the future swap fixed rate vis-à-vis 7.5 percent. Assume that the company's cost of funds can be decomposed into a benchmark Treasury yield plus a funding spread. Also, the swap fixed rate can be decomposed into the same benchmark Treasury yield plus a swap spread. If the corporation undertakes your recommended strategy, what is the basis risk? That is, how does the performance of the strategy depend on the relationship between these two spreads? Do you expect positive or negative correlation between corporate funding spreads and swap spreads?
Select one of the alternatives for the corporation. Read the facts of the case over again and, if necessary, the product descriptions. Playing with the payoff diagrams might be useful. Even if you are unsure about basis risk, make a recommendation for the derivatives strategy. Don't just skip to the solution.
Product descriptions
A typical callable bond is a fixed-income debt security that contains an embedded call option. The issuer of the bond has the right to buy the security back from the holder at designated prices (the call prices) on designated dates (the call dates). The issuer effectively has bought a call option on the underlying bond from the investor; the investor in turn has written that option. The premium paid by the issuer for the embedded derivative takes the form of a higher coupon rate than on a noncallable bond with the same maturity, assuming each can be issued at par value.
The issuer will exercise the option at a call date if its funding cost has gone down because of lower market interest rates (or perhaps because of an upgrade in the issuer's bond rating). The yield to maturity on the callable bond is higher than on a noncallable bond to compensate the investor for the inherent call risk. This is the risk that if the option is exercised, the cash proceeds will have to be invested in a bond earning a lower yield. There is typically a set time period after issuance, during which the bond cannot be called. The longer this call protection period, the lower is the yield on the bond because of the lesser extent of call risk.
A forward interest rate swap has a deferred rather than an immediate start date. Like a plain-vanilla swap, it entails an exchange of cash flows between two counterparties. One party (the buyer of the swap) commits to pay a fixed interest rate and the other (the seller of the swap) a floating reference rate that resets each period according to the current money market conditions. Cash settlement each period is usually on a net basis—the difference between the fixed rate and the floating rate, times the fraction of the year, times the amount of notional principal. If there is no initial payment from one counterparty to the other, the swap fixed rate is known as the at-market rate—that is, the going market rate. If one party makes an initial payment to the other, however, the fixed rate is an off-market rate. The amount the payment is calculated as a present value based on the difference between the contractual rate and the at-market rate.
A 2 x 5 forward swap is a three-year interest rate swap that is deferred for two years. The terms of the swap (that is, a 7 percent fixed rate, a $50 million notional principal, a reference rate of six-month Libor and semiannual settlements) are all set now, but nothing happens for the first two years. Then, for the subsequent three years there will be a net settlement payment every six months between the counterparties, depending of the observed level of Libor for each period, compared with 7 percent.
A payer swaption is an option to enter an interest rate swap as the payer of the fixed rate. If the option is exercised, its writer is obligated to enter the swap as the counterparty paying the floating reference rate. All the terms of the swap will have been set in advance. Typical of options contracts, the writer receives an upfront premium payment. A payer swaption will be in-the-money to the holder, and thereby have intrinsic value, if the current swap fixed rate at the time of exercise is more than the designated strike rate. In effect, the payer swaption allows its holder to pay a below-market fixed rate for receipt of the reference rate—for example, six-month Libor.
A receiver swaption is an option to enter an interest rate swap as the receiver of the fixed rate. The writer of the option collects the upfront premium but is obligated to enter the swap as the payer of the fixed rate if the option holder chooses to exercise. The holder of the receiver swaption will elect to do that if the current swap fixed rate is lower than the strike rate. The holder of the receiver swaption is able to receive an above-market fixed rate (that is, the strike rate) in exchange for the floating reference rate. Swaptions can be American-style (exercisable at any time prior to expiration) or European-style (exercisable only on the expiration date). The underlying commodity in a European-style swaption is a forward interest rate swap.
The payoff diagrams for the four products are illustrated in Figure 2. Notice that the horizontal axis is the level of interest rates, not prices. That is why the payoff on the embedded call option owned by the issuer of the callable bond might at first glance look like a put option. That option becomes more valuable as interest rates go lower, meaning as bond prices go higher. Also, the option premiums paid by the buyer to the writer are not included in the diagrams. If they were, the payoff lines would be shifted downward for the owners of the options and upward for the writers. Finally, the relationship between interest rates and the gains and losses are shown to be a straight line to simplify the diagrams. In fact, the payoffs are the present values of a series of cash flows, so the actual relationships are nonlinear.
The diagrams illustrate two key points about derivatives. First, they are zero-sum games in that the combined payoffs to the holder and the writer of the options (or the buyer and seller of the swap) net to zero for any level of interest rates. Second, put-call-forward parity links the theoretical pricing of options and forward markets. Here the combination of buying (writing) the payer swaption and writing (buying) the receiver swaption generates the same payoffs as committing to pay (receive) the fixed rate on a forward interest rate swap. Therefore, if the fixed rate on the forward swap is the at-market rate, then the premiums on the payer and receiver swaptions will be equal, regardless of the level of volatility in the market (neglecting transaction costs). If the premiums are not the same, the difference between them will equal the upfront payment on the comparable off-market forward interest rate swap.
The "Good Banker” solution
I have used this exercise in many, many derivatives and risk management training courses over the past 10 years. I have used it with junior and senior bankers, with derivatives traders and their back-office personnel, with corporate treasurers, and with newly hired MBAs. A persistent pattern holds—about half of the groups get it right and half get it wrong. I have come to see this as an exercise in problem identification. The choice inevitably comes down to which particular facts in the case the groups hear and therefore focus on.
The "Good Bankers,” of course, recommend that the corporation write the receiver swaption. They hear that the "essence of the risk management problem is that the call option is embedded in the bond.” The solution is the strategy well known within the derivatives marketing world as call monetization. The idea is to cash out (that is, to monetize) the embedded option position by selling an (almost) equivalent option in the OTC derivatives market. The premium collected on the receiver swaption, which here is $3.5 million, captures the value of the embedded call option.
This strategy is depicted in Figure 3. The upper panel combines the payoff diagram for the holder of the embedded call option with the payoff to the writer of the receiver swaption. Here the premium received on writing the swaption is included in the payoff diagram. The lower panel shows the desired flat line result that eliminates exposure to future interest rates. If interest rates rise in two years (that is, the corporation's three-year cost of funds is above 8 percent and the three-year swap fixed rate is above 7.5 percent), both options are out-of-the-money and expire worthless. If rates fall, the gains on buying back the callable bond and refinancing the debt offsets the losses on the written receiver swaption.
The basis risk inherent in the strategy is that the gains and losses when interest rates fall might not be equal. This will happen if there are changes in the corporation's funding spread and the swap spread, each over the benchmark three-year Treasury yield. The net position will rise, improving the performance of the strategy, if the corporation's funding spread goes down or if the swap spread goes up. However, the opposite happens down if the funding spread falls or if the swap spread rises. Fortunately, these spreads typically move in the same direction; that is, they are positively correlated. This is because the same set of market risk factors tends to drive corporate as well as commercial bank spreads over Treasury yields. That fact tends to mitigate the basis risk in the call monetization strategy.
The "Bad Banker” solution
About half of the groups that do this exercise end up recommending that the corporation buy the payer swaption. Invariably, these groups hear and focus on the treasurer's strongly held view that interest rates have bottomed and will be rising in the future. They opt to recommend a strategy that in some quarters is known as view monetization. The idea is to put the treasurer into a derivatives position that will make money if the held view on market conditions prevails.
This strategy is illustrated in Figure 4. Notice that the net outcome is an interest rate straddle—the corporation stands to gain if market rates rise enough or fall enough to offset the premium paid on the payer swaption. Note that the basis risk is the same as above—the strategy does better (worse) if the corporation's funding spread falls (rises) and if the swap spread rises (falls).
Some participants are surprised, some even indignant, to find that they are "Bad Bankers.” They argue, "How can we be wrong if we put the customer into a derivative that fully reflects his market view?” That's when I launch my "you've got to listen to the customer” sermon. I reread the facts of the case to them, emphasizing the two places that state the treasurer's expectation of higher interest rates. But then I remind them that at no point whatsoever does the treasurer suggest that he would want to act on that rate view. Instead, he clearly wants to capture the current value of the embedded option he already owns. There is no indication that he wants to speculate on higher rates (let alone being authorized to do so), which is exactly what putting him into the straddle will do. (See Figure 5.)
Sometimes a commercial banker, usually one new to derivatives, will say something like, "We're told to talk about interest rates and find out the customer's view. We're told to sell derivatives. But how can we sell derivatives if we don't recommend that the customer buy the product?” I explain that the bank makes just as much money buying derivatives (as when the corporation writes the receiver swaption) as it does selling derivatives (when the corporation buys the payer swaption). It is obvious to traders, but others often are surprised to learn that the two strategies are equally profitable to the bank.
Conclusion
Corporate treasurers have to have a view on market interest rates. That rate view is a key factor in making interest rate risk management decisions. In this exercise the treasurer has a strongly held view and he has a problem—he already owns an option that will lose value if his expectations turn out to be right. It's tempting to just build the derivatives strategy around that view. That's what the "Bad Bankers” do—they put the customer into a speculative position. The "Good Bankers” listen better and identify the source of the problem—the owned option is embedded in the callable bond. The correct solution is to write an option that has the effect of closing out the existing position and locking in its current value. The next step in the analysis leads to the murky world of derivatives accounting and FAS 133, the new financial accounting standard. But that discussion goes beyond this exercise.
This exercise is based on "Forward Swaps, Swap Options, and the Management of Callable Debt” by Keith Brown and Donald Smith, which appeared the Journal of Applied Corporate Finance, Winter 1990. Smith can be reached at DonSmith@bu.edu.
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