Yield Curves (term structure of interest rates) – filling in the blanks

| 27-05-2016 | Lionel Pavey

Most treasurers do not have access to a dedicated financial data vendor (Bloomberg, Reuters) but are regularly faced with having to discover prices related to yield curves. There are websites that can provide us with relevant data, but these are normally a snapshot and not comprehensive – the data series is incomplete. It is therefore up to the treasurer to complete the series by filling in the blanks.

A quick refresher about the construction of a yield curve raises the following points:-

  • All data must be from the same market (treasury bonds, Interest Rate Swaps (IRS) etc.)
  • A regular term (maturity) is preferred for ease of construction
  • A curve must be smooth
  • An implied zero yield curve can be built from the smooth par curve – a theoretical yield curve where no interest is paid until maturity. In a bond this would redeem at par (100) and be issued at a deep discount to par
  • A series of discounted cash flow factors (DCF) are produced
  • An implied forward curve with constant maturities can be built from the par curve
  • An implied forward curve must be monotonic – each point in an increasing sequence is greater than or equal to the preceding point, each point in a decreasing sequence is smaller than or equal to the preceding point

If we look at IRS par yield prices that can be found on a website, we can regularly see yield prices for periods from 1 year to 10 year inclusive, a 15 year price and a 20 year price. To construct a complete curve from 1 year up to and including 20 years we need to fill in the blanks at 11,12,13,14,16,17,18 and 19 years. These yields are assumed to be par yields – the coupon rate is equal to the yield to maturity and the instrument trades at par.

Before starting let us define the procedure for constructing a par yield curve:-
The methodology used is called “bootstrapping”. This allows us to extract discount factors (DCF) from the market rates. DCF’s allow us to calculate a value today for a cash flow in the future.

We assume that the nominal value for all calculation purposes is 100

For a 1 year rate we know the interest and redemption amount at maturity. A DCF is built whereby the net present value (NPV) of these future cash flows in 1 years’ time is equal to 100 or par.

For a 2 year rate we receive interest after 1 year and interest and redemption amount at maturity.

We discount the 1st years’ interest with the DCF we obtained from the 1 year rate and deduct this amount from our initial nominal of 100. This net amount is then divided by the interest and redemption at maturity (at end of 2 years) to obtain the DCF for the 2 year rate.

Example:

1 Year                                      7%                          2 Year                          9%

1 Year      
100 / (7/100+100) = 0.93457944 (DCF)

2 Year
9 * 0.93457944 = 8.41121496
100 – 8.41121496 = 91.58878504
91.58878504 / (9/100+100) = 0.8402640829

These DCF’s can then be used to find the NPV of any cash flow maturing in 1 or 2 years’ time.

The following example shows a yield curve from February 2013 published on the website of an interbank broker.

yield curve February 2013

yield curve February 2013

The quickest way to price the missing periods would be with straight line interpolation of the par curve between the known points – which would produce the following par curve, zero yield curve and forward curve with constant 1 year maturity.

yield curve February 2013 - 2

yield curve February 2013

Straight line interpolation

Straight line interpolation

 

Whilst the par curve and zero curve are smooth, the implied 1 year constant maturity curve is jagged and certainly neither smooth nor monotonic. The 11th 1 year period rate is lower than the 10th period and the 15th 1 year period rate is higher than the 16th period.

A second approach would be to apply a weighting to the known periods of the par curve and to average the difference out over the missing periods. Read more on this second approach in my next article which will appear next week.

Lionel Pavey

 

 

Lionel Pavey

Treasurer

 

 

Coco goes Loco!

26-05-2016 | by Pieter Jan van Krevel |

The title of this article does not pertain to mademoiselle Coco Chanel losing her marbles, nor to a small, furry animal going berserk over its squeaky toy. In this case, it refers to the Contingent Convertible bond (‘Coco’): a financial instrument that lately seems to have fallen from grace with the investment crowd.

While contingent convertibles exist on other securities for some time now, since the last financial crisis they have become quite popular amongst banks that use them to prop up their core tier 1 capital[1]. Similar to the hybrids from an almost bygone era, Cocos are hybrid securities that allow banks to consider them as equity. Why? Because they will either convert into equity, or be written off, if tier 1 capital falls below a preset threshold.[2] Cocos are (thus) heavily subordinated and carry a commensurate yield.[3] Or at least so it appeared.

Why then is their reputation going south? A first hiccup in their rise to popularity was caused by the implementation of the Basel III regime, under which not all Cocos are eligible for inclusion in tier 1 capital. Cocos with clauses on regulatory changes allow early redemption in that event, and when Lloyds wanted to call USD 5bn worth of Cocos on this ground, (legal) hell broke loose. Recently the UK Court of Appeal announced it would consider the previous appellate ruling allowing early redemption. The jury is still out, so to say.

This is not the only clause that can spoil the investors’ party. Common others are the issuer’s right to (indefinitely) skip interest payments, or postpone redemption. The latter can be as simple as just not call a callable perpetual, and thus ‘convert’ a Coco previously priced to first call in, say, 5 years, into an ‘real’ perpetual. Imagine what that does for NPV…!

Coco’s popularity took another hit last February, when rising concerns about Deutsche Bank’s performance – and even viability – triggered speculation about DB having to skip coupon payments on its Cocos, caused by some rather obscure accounting idiosyncrasy. Chaos quickly spread to other Cocos, bank stocks and bonds alike.

UBS‘ March 14 issuance of a new USD 1.5bn Coco proves things have quieted down somewhat, but investors have become more aware of both the complexity and the risks Cocos bear. It seems that the market is realizing that, as ever, there is no such thing as a free lunch. Not even a meagre loaf of coco bread.

[1] First Coco issued in November 2009 by Lloyds Banking Group, with Rabobank following suit in March 2010.

[2] Some, qualifying, Cocos are also referred to as ‘AT1’ – Additional Tier 1. These are considered the riskiest debt issued by banks.

[3] The 2010 Rabobank issue was e.g. priced at 300bps over a similar but non-convertible loan.

Pieter Jan van Krevel

 

Pieter Jan van Krevel

Owner at Slàinte Mhath!

Treasury Education: great but do not expect career miracles. Do make a strategy.

| 25-05-2016 | Pieter de Kiewit |

studyLast week I visited an information session about financial postgraduate education. It was organized by the VU (Vrije Universiteit, Amsterdam). I noticed an increased interest in comparison to last years session, which is great. Information was provided about courses I see back in the CV’s of treasurers: CFA, RBA (Register Belegging Analyst) and of course RT (Register Treasurer) that has an overlap with the ACT courses. Education, specifically postgraduate, is a topic that returns in many of my meetings. This is what I notice on the topic:

Investing in education is like investing in your network: if you start thinking about it when the need is urgent, you are too late and you will have to work harder. Education as a topic comes up, most of the time, when somebody is planning his career strategy, being in a position or when somebody is between jobs. In the first situation I often notice an intrinsic motivation, eagerness for knowledge and curiosity about other people’s experience. Elements for a solid basis to complete the education.

Candidates that lack these elements often have a harder time to complete their education. Even when they are willing to invest their own money. Furthermore, candidates that are between jobs are open for a broader range of positions than those who search from being employed. This makes it harder for the unemployed to choose which education to pursue. To complete this negative list, regretfully employers often do not have a good understanding of the value of specific treasury courses. In our assignments postgraduate treasury education is hardly ever a dealmaker or a deal breaker.

This is not a plea to stop learning! Treasury education is always great. Sometimes timing can be improved. This is a plea to plan ahead, about your career and education.

If you want to brainstorm, contact me. And let me know what your thoughts are.

Pieter de Kiewit

 

 

 

Pieter de Kiewit
Owner Treasurer Search

 

 

Option Tales: Cheap Options Part II

| 24-05-2016 | Rob Söentken |

bankingToday in Rob Söentken’s Option Tales: When buying options it is tempting to see if the premium expenses can be minimized. A number of solutions are possible, which will be discussed in four articles. In the previous article I talked about the first two solutions: Choose the strike further OTM and Choose shorter tenor. Today I will be discussing the next two solutions: Choose the longer tenor and the Compound option.

 

3- Choose longer tenor

Following the comparison between a 3-month and a 12-month option, it should be remembered that a 12-month option will have some remaining value after 3 months have passed, at least theoretically. If we assume ‘ceteris paribus’ (everything remained unchanged) the remaining option value of a 12-month option would be 1.1%. If we diagram1pt2bought the option for 1.5%, we could sell it after 3 months at 1.1% and buy the USD through an outright forward transaction. This approach shows that the net cost of option protection would be only 0.4% (1.5% – 1.1%). Which would be cheaper than the premium of a 3-month option with the same Delta. Also, because the option has a higher Delta than a 3-month option with the same strike (25% vs 10%, see diagram 2), it will follow the spot market much better. The bottom line of paragraph 3 is that a longer dated option can be bought with the intention to sell it again at some point, the net cost being less than buying a shorter dated option. While it serves as a hedge against price changes.

4- Compound option

A compound option is the right to buy an option against a certain premium. For example we could be considering todiagrampt2 buy the 1-year option in diagram 2 for 1.5%. Alternatively we could consider buying a right to buy this option for 0.4% in 3 months time. At that time the 1-year option will only have 9 months remaining, but the strike and 1.5% premium are fixed in the contract. On the expiry date of the compound option we can decide if we want to pay 1.5% for the underlying option. Alternatively, assuming nothing has changed, we could buy a 9 month option in the market for 1.1% (see diagram 2). In such a case we wouldn’t exercise the compound option.

An alternative to the compound option would be to buy the 3-month option for 0.2%. On expiry, assuming nothing has changed again, we could buy a 9 month option in the market for 1.1% (see diagram 2).

In my next two articles I will discuss the last two solutions for minimizing premium expenses when buying options:

  • Conditional Premium option
  • Reverse Knock Out

Would you like to read more in Rob Söentken’s Option Tales?
1. Options are for wimps
2. ATM or OTM
3. Cheap options part 1

 

Rob Soentken

 

 

Rob Söentken

Ex-derivatives trader

 

Cash flow forecasting (CFFC)

23-05-2016 | by Udo Rademakers |

In recent years and months, we have seen quite a few companies coming into liquidity problems, leading in worst case scenario to insolvencies. This brings us to the question: how important is cash flow forecasting? How to anticipate adequately and to avoid facing “surprises” at the last moment and how should you implement it?
The Cash flow forecast (CFFC) estimates the timing and amounts of cash in- and outflows over a specific period and in different time buckets (day, week, month, year). It provides you with an actual overview of the cash position and with a forecast.

Why is a cash flow forecast important?

  • based on the CFFC you can assure the timely payment to your suppliers, employees and finance providers (at all times as you want to avoid liquidity problems!)
  • it can act as a management tool and “early warning system”
  • the analysis of actuals versus forecast helps you to identify possible problems  (e.g. delay in invoicing to customers, late payments to suppliers)
  • the analysis of forecasts versus forecast helps you to identify the trend and to understand the business much better
  • the aggregated information shows if you are able to cover your financial obligations towards finance institutions/investors in the longer term and if your cash flow could meet the covenant targets or whether there will be a breach of credit facility limits. In case of a “cash rich” position it helps you to decide how much money and for which period you could invest it
  • A CFFC helps to identify foreign exchange exposures and it supports hedging decisions.

How to implement a CFFC?

Depending on the turnover, leverage, growth, systems, number of employees, internationality and currencies, the approach (and time effort) should fit the size of the organisation.

Cash flow forecasting often doesn’t have priority within organisations. However, as a treasurer, we realize the added value and need of it but also do realize that making a good CFFC could cost a lot of (time) effort. So how could we get a timely and reliable CFFC process in place without using all precious time of the finance managers?

  1. automate where possible: use either sophisticated spreadsheets, but even better, a sophisticated web based application or use the functionalities of your Treasury Management System (and fine-tune it)
  2. import centrally (via MT940) the actual banking balances where possible
  3. use your (invoice payment due dates) AP/AR data for the short term FC
  4. let fill out the “gaps” by finance managers based on their business knowledge
  5. make sure everyone reports the latest data in time with an explanation of high impact changes and actual versus realisation differences
  6. undertake actions where needed
  7. consolidate the data, analyse the information and report the highlights to the senior management on a regular basis.

 

 

 

Udo Rademakers

Treasury Consultant

Uitgelicht: Angst voor brexit jaagt bedrijven naar de beurs

| 20-05-2016 | treasuryXL |

brexit

 

Recentelijk lazen we een aantal berichten over de angst voor Brexit die meerdere bedrijven naar de beurs jaagt. (bron: FD, NRC) Onder andere Philips, Basic Fit en ASR kondigden aan naar de beurs te gaan.  treasuryXL vroeg een drietal experts om hun mening;

 

Is het inderdaad de angst voor Brexit die bedrijven naar de beurs drijft?

Douwe Dijkstra

 

Douwe Dijkstra – Owner of Albatros Beheer & Management
“Angst voor een Brexit jaagt bedrijven naar de beurs” lees ik op een aantal sites en hoorde ik in het journaal. En de beoogde investeerders dan? Die hebben dit nog niet door? Ik geloof wel in een Brexit en daardoor een eenmalige spike naar beneden van GBP en beurzen maar verwacht daarna snel herstel. Naar mijn gevoel zijn beurzen wel toe aan een rit naar boven.

 

Roger Boxman

 

Roger Boxman – Interim Risk Management Consultant
Bedrijven houden rekening met een ongunstig beursklimaat. De verwachte opbrengst zal tegenvallen bij een ‘no’ vanwege een lagere Britse Pond en een hogere vereiste risicopremie bij beleggers. Enige nuancering is op zijn plaats. Zo is Zwitserland geen lid van de EU, maar herbergt vele succesvolle multinationals. En zo heeft de Griekse toetreding tot de EU en de Euro na aanvankelijk succes de nodige rampspoed gebracht.

 

Rob Soentken

 

Rob Soëntken – ex-derivates trader
De komende maanden gaan er verscheidene Nederlandse bedrijven naar de beurs. De onzekerheden omtrent een mogelijk Brexit spelen daarbij zeker een rol. Helemaal nu het kiezer sentiment in de VS de republikeinse kandidaat Trump sterk in de kaart speelt, lijkt ook een door het volk afgedwongen Brexit een reëel mogelijke ontwikkeling. Toch moet niet vergeten worden dat deze informatie reeds in de markt is verwerkt. Dus zou men kunnen stellen dat zodra dit achter de rug is, ongeacht het resultaat, de neerwaartse druk op de beurs zou wegvallen. Niet direct, maar langzaamaan. Natuurlijk zijn er momenteel risico’s, maar die zijn ingeprijsd.

 

When plain crazy just isn’t mad enough

| 19-05-2016 | Pieter Jan van Krevel |

pieter jan krevel

So everybody knows about cat bonds. No, not corporate bonds issued by Caterpillar, but bonds linked to catastrophes. Sounds exciting, right?

Cat bonds were originally devised in the mid-1990s after Hurricane Andrew and the Northridge earthquake, both wreaking (financial) havoc in the U.S.
The financial havoc befell insurers, and the inception of the cat bonds stemmed from these events that cost the insurers a combined estimated USD 39 – 66 bn (1990s dollars). This hurt, so they devised a way to shift this risk in case disaster struck (in lieu of traditional reinsurance).

The principle is simple: investors get a handsome coupon (+300-2,000 bps spread) on a, generally, short-dated sub-investment grade bond (up to 3 yrs BB/B), if and only if, disaster does NOT strike. If it does strike, however, the investors forego their principal (let alone the coupon), and the insurers use this ‘windfall’ to pay the claims emanating from the disaster. These catastrophes, and therefore the cat bonds, are pretty much totally uncorrelated with any other asset class in a portfolio, and thus interesting and effective diversification material.

So far, so good.

But what if we take this a little further: in a way, a CDS can also be considered a cat bond. After all, we’re talking binary pay-off here. While I will not go into the (de-)merits of CDSs here, ‘disaster’ is a word that comes to mind when looking at the bloodied and mangled remains of many a CDS. But let’s leave that for another day

However for the final leap of faith we need to look at the Swiss: Credit Suisse has apparently invented the ultimate capital-relief instrument. Recently, news got out that Credit Suisse intends issuance of a special cat bond, linked to ‘operational risks’ by, amongst others, ‘failed internal processes’. We’re talking about external events, business disruptions (e.g. cybercrime), trade processing errors and, hold on to your seats, failures in regulatory compliance and rogue trading. So, when a Credit Suisse trader screws up its book (or someone else’s for that matter), the cat bond will be triggered and the trading losses will be (partly) absorbed. I fully agree to the premise that a screw-up in proprietary trading spells disaster nowadays – just think of Mr. Kerviel and JPMorgan’s London Whale to name but two.

However, there is one minor detail that sets this kind of catastrophe apart from the natural disasters that cat bonds started out to ‘reinsure’: these are man-made (financial) catastrophes, and can (and should) be mitigated by the checks and balances that financial institutions claim, and are obliged, to employ these days. Not to mention the fact that offloading risks by banks to insurers went a long way to melt down the global financial system in 2008. Who needs Andrew or Katrina when you’ve got quants and prop traders?

Sounds like a ‘Get out of jail free’ card to me. Although I am not quite sure whether Messrs. Leeson and Kerviel agree…

Pieter Jan van Krevel

 

Pieter Jan van Krevel

Owner at Slàinte Mhath!

EUR/USD Outlook

18-05-2016 | by Simon Knappstein |

 businesspaper

The US Dollar is currently going through a soft spell. Most markedly against EM, but also against the EUR. Upside seems contained so far by the very easy monetary policy of the ECB. The question is if we are witnessing simply an extension of the ranging price movement as seen in the last 5 quarters or whether this is the start of a lasting recovery?

 

 

FX Prospects consensus forecast for EUR/USD is 1.1020 in 3 months and 1.0810 in 12 months.

outlook eur/usd

Let’s take a closer look at the arguments that argue for a higher EUR/USD than consensus.
Danske Bank is in the longer term the most bullish, forecasting a shallow move lower to 1.12 in 3 months and a subsequent move higher to 1.18 in 12 months.
Nordea is looking for a move to 1.16 in 3 months only to see the pair fall thereafter to 1.05 in 12 months.

Danske is expecting for relative rates to play a more important role in the near term where the ECB will be challenged once again on its mandate by market inflation expectations and the Fed might turn out a bit more upbeat on a September rate hike. This, coupled with a Brexit risk premium weighing on the EUR as well, should lead to some downside in the next 2 or 3 months. Further out, they expect valuation to drive the EUR/USD higher to 1.18.

Nordea on the other hand, sees the EUR strengthening in the near term on a combination of a diminished likelihood of deeply negative rates by the ECB, potential risk aversion that leads to some EUR short covering and a dovish shift in the Fed’s reaction function. Further out then, as this dovish shift is reflecting an undue focus on domestic- and global risks (Brexit, China) that do not materialise, a hawkish re-pricing of the curve will support the USD at the same time that increasing inflation in the EZ is lowering real rates and leading to EUR-negative portfolio outflows. Bringing EUR/USD to the aforementioned level at 1.05 in 12 months.

These are two very different views on where EUR/USD is heading. It is not though, a matter of who is wrong and who is right. Opposing opinions help you make up your own mind and improve on your investment decisions.

 

Simon Knappstein - editor treasuryXL

 

Simon Knappstein

Owner of FX Prospect

 

 

 

Option Tales: Cheap Options Part I

17-05-2016 | By Rob Soentken |

banking

 

Today in Rob Soentken’s Option Tales: When buying options it is tempting to see if the premium expenses can be minimized. A number of solutions are possible, which will be discussed in four articles. Today I’m discussing the first two solutions: Choose the strike further OTM and Choose shorter tenor.

 

1-Choose Out of The Money (OTM) Strike

Hedging the purchase of a certain amount of USD could be done by purchasing a USD call option with the strike set At The Money (ATM). In diagram 1 it shows that such an option would costs about 2.0%. The strike is 0% OTM, so ATM. A strike further OTM would cost less premium. For example, a strike set at 3% OTM would costs only 0.8%. The cost saving is 1.2%, but also the protection kicks-in only after USD has appreciated by 3%. Should we need to exercise the option to get our USD, it still means a combined hedging cost of 3.8%. Which is more than if we had bought the ATM option for 2% premium. Conclusion: Buying an OTM option reduces the up-front cost versus buying an ATM option. But ex-post hedging with an OTM option could result in total hedging cost which are higher than an ATM option.

2- Choose shorter tenor

Hedging the purchase of a certain amount of USD in 1-year time could be done by purchasing a USD call option with 25% chance of exercise. In diagram 2 it shows that such an option would have a strike 6.2% OTM and would cost 1.5%. Options with the same strike but with a shorter tenor would cost less up front. For example: choosing a 3-month time to expiry would make the option premium 0.2%. It must be noted that while the 3-month option has the same strike as the 12-month, its chance on exercise (Delta) is substantially less. By itself choosing a 3-month tenor is not ‘wrong’ when hedging a 12 months USD flow. It is just the on the expiry date of the option either the option is exercised, or the USD must be purchased from the market at the prevailing rate.

 

 

In my next two articles I will discuss the following solutions for minimizing premium expenses when buying options:

  • Choose longer tenor
  • Average rate option
  • Conditional Premium option
  • Reverse Knock Out

Want to read more in Rob Soentken’s Option Tales?

Option Tales – Options are for Wimps
Options Tales – ATM OR OTM?

 

Rob Soentken

 

 

Rob Soentken

Ex derivates trader

Business case – Funding strategy : how Fastned uses Nxchange

| 09-05-2016 | interview with Claire Tange from Fastned

Fastned’s growing and they’re giving investors the chance to directly buy and trade in certificates of shares via Nxchange. We’ve asked Fastned’s CFO Claire Tange to explain this type of financing.

 

What is new about this type of financing?

Fastned is now listed on a new pan-European regulated stock exchange called Nxchange. This new stock exchange cuts out the middleman (the broker). This means that investors in Fastned can directly buy and trade in certificates of shares via the Nxchange website. Also, there is a strong social component to the exchange. It’s like Euronext meets LinkedIn.

How would you describe the process?

Because Nxchange is a fully regulated stock exchange, Fastned has to comply with all the regulations that also hold for companies listed on e.g. Euronext. That means that a.o. we changed our accounting to IFRS reporting and that we filed a prospectus with the AFM. This was an intense process, but we did it.

Which alternatives did you consider?

Fastned already had a listing on NPEX, but we felt that we needed a bigger exchange to raise more capital. Given the fact that Nxchange is a fully regulated stock exchange this opens the doors to funds that hold this as a prerequisite. Also, the new exchange offers benefits to our investors, such as vastly improved liquidity.

What are the risks in comparison with other types of financing?

Nxchange is a step between crowdfunding and Euronext. It offers the comfort of a regulated market without the illiquidity of crowdfunding. Like any investment, an investment in Fastned has risks associated with it. We are a new company in a new market. On the other hand, Fastned is infrastructure. Investments are backed with tangible assets. And in the end, the business model is ‘good old’ retailing. We sell electricity on location. Perhaps not so exotic after all.

What are the benefits for you?

Fastned has a very strong community that wants to support the company and the mission we are on. Nxchange is the way to engage and expand our community. We started with the EV enthusiasts but now more and more ‘regular’ investors are joining in.

What are the benefits for people joining?

For Nxchange: Investing in fast growing companies directly on the exchange. Fastned is the first but definitely more will follow. For Fastned: Investing in a huge growth market. If you believe in the transition from fossil fuel powered cars to electric cars you will realise that this will create huge opportunities. In Europe alone 500 billion Euro worth of sales of diesel & petrol annually will shift to electric. Fastned is one of the leading companies in this transition.

If you want to know more about investing in Fastned please visit their website.

Claire TangeClaire graduated as chemical engineer at the TU Delft. After an internship with JP Morgan she decided to pursue a career in the financial sector. She continued as investment banking trainee with ABN Amro / RBS and for almost six years, half of which in London, she worked in M&A and Corporate Finance. Since 2006 Claire was increasingly involved in renewable energy projects in faraway places (Antarctica, Himalayas) and from there on it was a small step to join Fastned and strengthen the team with her financial expertise.