Replicating Interest Rate Swaps with Eurodollar Strips - MemoFin.fr

eceiver) is generally referred to simply as the“payer” while the fixed rate receiver (floating ratepayer) may be referred to simply as the “receiver.”Interest Rate Swap (IRS)For example, one may swap a quarterly paymentbased upon a specified fixed rate of interest, such as1%, applied to a principal value of $10 million forthe next 5 years; for a quarterly payment basedupon 3-month LIBOR rates applied to a principalvalue of $10 million for the next 5 years. Theseperiodic fixed vs. floating rate payments are typicallynetted such that only the net amount due is passedbetween payer and receiver.Clearly, the fixed rate payer hopes that floatingrates rise such that his future receipts are increased.The floating rate payer, or fixed rate receiver, hopesthat floating rates decline such that his futurepayments are diminished.ED Volume (Mill Cnts)FixedRatePayer1,0009008007006005004003002001000FixedPaymentsFloatingPaymentsEurodollar & IRS Growth1981198319851987198919911993199519971999200120032005200720092011EurodollarsDealerFixedPaymentsFloatingPaymentsIRSFixedRateReceiver$450$400$350$300$250$200$150$100$50The seminal interest rate swap transaction wasconcluded in 1980 while Eurodollar futures wereoriginally introduced in 1981. Since that time the$0Outstanding IRS (Trillions)IRS market has grown to some $379.4 trillion inoutstanding notional value as of June 2012. 1Volume in CME Eurodollar products have grown on astrikingly parallel path along with over-the-counterswaps. This underscores the fact that Eurodollarfutures and inextricably intertwined with the IRSmarket as a source for pricing and a tool to hedgethe risks associated with swaps. In particular, banksand broker-dealers making a market in over-thecounter(OTC) swaps represent primary Eurodollarmarket participants.BBA LIBOR SwapThe British Banker’s Association (BBA) LIBOR fixingsrepresent a benchmark against which many interestrate products including CME Eurodollar futures andinterest rate swaps routinely are pegged. Becauseof this focus on the BBA LIBOR fixing rate and theliquidity associated with Eurodollar futures, aparticular type of IRS – a “BBA LIBOR Swap” – isfrequently traded in the over-the-counter (OTC)markets.A BBA LIBOR Swap may be constructed to referencethe 3-month BBA LIBOR fixing as the basis for thefloating rate payments, frequently on the samedates as standard CME Eurodollar futures are settled(so-called “IMM dates”).As such, there is a closely compatible relationshipbetween BBA LIBOR Swaps and CME Eurodollarfutures that facilitates use of futures as a referencefor pricing, and a tool for hedging, swaps. Further,this implies that futures may be used as a proxy tomimic the performance of a BBA LIBOR Swap, albeitwith some qualifications. 21 As reported by the Bank of International Settlements(BIS) in its semi-annual survey of the over-the-counter(OTC) derivatives marketplace.2 Note that, unlike OTC swaps, CME Eurodollar futures donot exhibit convexity, or a non-linear relationshipbetween price and yield. Rather, futures exhibit a linearrelationship such that a one basis point (0.01%) changein yield uniformly represents a monetary change of$25.00 in the value of a single futures contract. Thislack of convexity implies that one must adjust one’sEurodollar position periodically in order to achieve asimilar effect.3 Replicating IRS with Eurodollar Strips | May 16, 2013 | © CME GROUP