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Market Strategy Americas: Derivatives

US Economics Research and Market Strategy June 2, 2008 This is an excerpt from the MSA Weekly, published May 29, 2008

Back to Basics: OIS Swaps and Related Instruments

Ajay Rajadhyaksha, Piyush Goyal OIS swaps have become more prominent over the last few months, for several reasons. For one, Libor and fed funds have decoupled (Figure 1) since the credit crisis started a few months ago. Since mid-April, there have also been heightened investor suspicions about Libor fixings. Moreover, in December 2007, the Federal Reserve announced that 1mth OIS would be the minimum bid rate for loans available from its Term Auction Facility (TAF).

Figure 1: Comparison of 1mth OIS and 1mth Libor

6 5.5 5 4.5 4 3.5 3 2.5 2 1.5 Jan 07 Mar 07 May 07 Jul 07 Sep 07 Nov 07 Jan 08 Mar 08 May 08 1mth OIS 1mth Libor

Note: Data period: January 2, 2007-May 28, 2008; Source: Bloomberg

All of this has increased the significance of OIS swaps as a hedging mechanism for shortterm interest rate risks. So we provide readers with greater details into the working of OIS swap markets. But before we do that, we wade into this debate about why Libor is unlikely to be replaced.

A Premature Death Knell for Libor

To paraphrase Mark Twain, rumors of the death of Libor have been greatly exaggerated. Admittedly, both Libor and OIS swaps are ways to position in short rates. And there are

Please read carefully the important disclosures at the end of this publication.

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problems with the way Libor is measured that make it a less-than-true reflection of bank borrowing costs. But there are two major roadblocks to OIS gaining popularity at the expense of Libor. Figure 2: Mortgages Tied to 6mth Libor
600 ARM Origination ($bn) 500 400 300 200 100 0 2003 2004 2005 Origination Year
Source: Barclays Capital Source: Barclays Capital

Figure 3: and 1yr Libor

350 ARM Origination ($bn) 300 250 200 150 100 50 0 2003 2004 2005 Origination Year 2006 2007 1yr Libor

6mth Libor

2006

2007

The first is the profusion of existing Libor-based contracts, of which the mortgage market makes up a big share. Figure 2 looks at the total amount of adjustable rate mortgage loans that are tied to 6mth Libor. Figure 3 shows similar figures for 1yr Libor. In total, nearly $2.4trn of loans are outstanding in the mortgage market that are tied to Libor. These are likely to remain outstanding for several years, especially in the current weak prepayment environment. To hedge this Libor risk, investors will probably end up using Libor swaps, flawed though they may seem. In addition, Libor swaps are more liquid. Short Libor swaps trade on the back of eurodollar futures, while short OIS swaps use fed funds futures. Both futures are exchange traded, but there is a world of difference in the breadth and depth of the two markets. Depth: The daily traded volume in ED futures is roughly 30-60 times that in FF futures. Breadth: 90% of FF futures trading is in the first six monthly contracts. Hence, OIS can be said to have liquidity for the first six months. ED futures, on the other hand, are fairly liquid up to three years, so Libor swaps are liquid up to three years.

Understanding Overnight Index Swaps (OIS)

So what exactly is an OIS swap? It is simply a fixed/floating interest rate swap. The floating leg is computed using a published overnight rate index. For USD, the floating leg is the geometric mean of the Funds Effective Rate (FER) 1 between the start to the maturity date. In an OIS transaction, the two parties agree to exchange at maturity the difference between the interest accrued using the fixed rate and the compounded floating rate. The payer (of fixed rate) benefits from rising rates and vice versa. The net payment is made two business days after maturity. These contracts are traded over-the-counter, have a day count

See Appendix: A for greater details on the Funds Effective Rate US Economics Research and Market Strategy Barclays Capital

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convention of ACT/360, and a maturity of 1wk to 5yrs. The contracts can be pulled up on Bloomberg using PREB <GO> 7 <GO>. Difference between fed funds futures and OIS: Though both derive their valuation from the FER, they can differ due to different accrual mechanisms (simple versus geometric mean). According to the ISDA conventions, the floating leg is calculated as follows:

d0 FedFund i * ni 360 . (1) 1 * 1 + 360 d i =1

Where:

d 0 : Number of New York banking days in the relevant calculation period;

d : Number of calendar says in the relevant calculation period;

FedFund i : Effective Funds Rate on day I; and ni : Number of calendar says on which the FedFund i is applicable.
Figure 4 depicts the cash flows to an investor who enters a receive fixed 1mth OIS transaction on April 14, 2008. The 1mth OIS then was 2.03%; the funds target rate was 2.25% and with an ease expected at the April 30 FOMC meeting, it reflected that the market expected more than a 25bp ease on the meeting date.

Figure 4: Cash Flows to the Fixed Rate Receiver

Dates 4/14/08 (Trade Date) 4/16/08 (Start Date) 5/16/08 (End Date) 5/20/08 (Settlement Date) Note: - N* r floating *31/360 N* OIS1m *31/360 Floating Leg Fixed Leg Net Payment 0 0 0 N*( OIS1m -

r floating )*31/360

OIS1m = 2.03%. Source: Barclays Capital

According to (1),

r floating = 2.1165%. (The Effective Funds Rate for April 16 to May 15, 2008,

is downloaded from Bloomberg FEDL01 Index). If N = $100mm, the floating leg = $176,372 and the fixed leg = $174,806. So the investor ends up paying $1,567 on May 20, 2008 to settle the transaction. So why did the investor incur a loss? Because the receiver of the fixed rate gains in a falling rate environment, and vice versa. Since actual easing was less than market expectations on April 14 (akin to rising rates), the trade had a negative P&L.

Fed Funds-Libor Basis

Next, we turn to the Libor-FF basis, a related concept. This has gained attention in recent months as a proxy for the health of bank balance sheets. And it has implications for swaps and swaptions, which are also Libor-based contracts: Figure 5 shows that the 2yr swap spreads are positively correlated with June libor FF basis. As the basis widened during mid-April, 2yr spreads widened and both came in as fears about Libor issues receded.
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Figure 6 notes that investors in the ULC of the swaption vol surface need to watch for the Libor-FF dynamics. A wider basis causes an increase in short-dated option prices relative to longer-dated ones. A fed funds versus Libor basis swap is a floating/floating interest rate swap with one leg reset at 3mth Libor every quarter and the other computed as the simple average of the FER over the same three-month period. At the end of each quarter, one party pays average FER over that quarter plus the basis swap spread and receives 3-month LIBOR set at the beginning of that quarter. These contracts are traded over-the-counter, have a day count convention of ACT/360, and a maturity of 3mths to 10yrs. The contracts can be pulled up on Bloomberg using PREB <GO> 8 <GO>. Figure 5: 2yr Swap Spreads Are Driven by June Libor FF Basis
100 95 90 85 80 75 70 1 Apr 08 2yr Swap Spd (L) June Libor FF Spd (R) 15 Apr 08 29 Apr 08 100
1.10

Figure 6: so Is Front-End Volatility

100 90 1.08 1.06 1.04 1.02 1.00 1 Apr 08 3mth 2yr - 6mth 2yr Vol Ratio (L) June Libor FF Spd (R) 15 Apr 08 29 Apr 08 40 13 May 08 27 May 08 80 70 60 50

90 80 70 60 50

40 13 May 08 27 May 08

Note: Data Period: April 1-May 28, 2008. Source: Bloomberg, Barclays Capital

Note: Data Period: April 1-May 28, 2008. Source: Bloomberg, Barclays Capital

As an example, the spot FF-Libor 3mth basis is 65bp on May 28, 2008. 3mth OIS is ~2% and 3mth Libor ~ 2.65%. This basis traded in a tight range of 10-12bp before June 2007. But as the mortgage credit crisis evolved, this basis widened. It only started tightening back once the Fed injected liquidity through rate cuts and various temporary programs such as the TAF, TSLF, and PDCF. OIS swaps could see more demand over the next few months as the problems with Libor are worked out. But it is also worth noting that one of the reasons why these problems came to the fore, and why investors suddenly cared, was that credit risk on the banking sector increased. If the normalization in financial markets over the last couple of months continues, these worries should fade and with it, interest in OIS swaps might diminish. Either way, it is very likely that this product will be used to complement Libor products, rather than replace them.

Appendix A: Federal Funds Effective Rate

The Fed Funds Effective Rate (FER) is the volume-weighted 1-day interest rate at which depository institutions (mostly banks) lend surplus balances at the Federal Reserve to each other. The Federal Open Market Committee (FOMC) sets the fed funds target rate (FTR) and the Reserve Bank of New York conducts open market operations to keep the FER close to FTR. Without the open market operations, FER can diverge notably from the FTR if there is skewed demand/supply for cash in the banking system. The index uses an ACT/360 day

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count and is reported daily by the Federal Reserve Bank of New York between 07:3008:00am EST for the prior business day. FEDL01 Index is the Bloomberg index.

Example
On May 27, 2008, FER = 2.23% and FTR = 2%. 2 The effective rate was notably higher than the target rate due to high demand for cash then. But the average FER for May is 2%, which is close to the FTR. So the Reserve Bank of New York has been able to keep the effective rate close to the target rate through its money market operations.

Source: Bloomberg US Economics Research and Market Strategy 5

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US Economics Research and Market Strategy Analysts

200 Park Avenue New York, NY 10166 USA Larry Kantor Head of Research +1 212 412 1458 larry.kantor@barcap.com Yan Cao Mortgage Strategy +1 212 412 5996 yan.cao@barcap.com Piyush Goyal Fixed Income Strategy +1 212 412 6793 piyush.goyal@barcap.com Philip Ling Fixed Income Strategy +1 212 412 3202 philip.ling@barcap.com Laura Rosner US Economics Research +1 212 412 2711 laura.rosner@barcap.com Nicholas Strand Mortgage Strategy +1 212 412 2057 nicholas.strand@barcap.com Dean Maki Head of US Economics Research +1 212 412 2614 dean.maki@barcap.com Derek Chen Mortgage Strategy +1 212 412 2857 derek.chen@barcap.com Sharon Greenberg Mortgage Strategy +1 212 412 5930 Sharon.greenberg@barcap.com Chirag Mirani Fixed Income Strategy +1 212 412 2099 chirag.mirani@barcap.com Matthew Seltzer Mortgage Strategy +1 212 412 1537 matthew.seltzer@barcap.com Ajay Rajadhyaksha Head of US Fixed Income Strategy +1 212 412 7669 ajay.rajadhyaksha@barcap.com Julia Coronado US Economics Research +1 212 412 1476 julia.coronado@barcap.com Rael Limbitco Fixed Income Strategy +1 212 412 5156 rael.limbitco@barcap.com Michael Pond Treasury and Inflation-linked Strategy +1 212 412 5051 michael.pond@barcap.com Rajiv Setia Fixed Income Strategy +1 212 412 5507 rajiv.setia@barcap.com

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