Sunday, June 29, 2014

investment bank as IRS market maker

See also - Trac Consultancy course handout includes many practical applications of IRS.

A) A lot of (non-financial) corporations (eg. AQQ) have floating interest cost from short term bank _loans_. (I did the same with Citibank SG. Every time I rolls the loan, the interest is based on some floating index.) For risk control and long term planning, they prefer a fixed borrowing cost. They would seek IRS dealers who gives a quote in terms of the swap rate -- dealer to charged fixed interest and "Sell floating interest" i.e. "Sell the swap" or "Sell Libor".

A muni IRS dealer would determine her swap rate using 70% Libor as the floating rate. For each tenor (3 months to 2 years) the ratio is slightly different from 70%.

B) On the other side of the river, a lot of bond issuers (eg IBM) have a fixed interest cost, but to lower it they want floating cost (pay floating). So they find IRS dealers who quote them a swap rate -- dealer to PAY fixed and Buy floating interest Income, i.e. dealer Buy the swap.

It's important to get the above 2 scenarios right.
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Q: Is it possible for Company A to directly trade with Company B without a dealer? It's improbable to find such a trading partner at the right time. Even if there is, transaction cost is probably too high.

The same dealer could give quotes to both clients. The 2 swap rates quoted are like the bid/ask "published" by the dealer. Dealer might want to pay 500bps for Libor; and simultaneously want to charge (receive) 530bps for Libor.

Dealer doesn't really publish the 2 swap rates because each IRS contract is bespoke. If a dealer happens to have both client A and B then dealer is lucky. He can earn the difference between the 2 swap rates. Usually there's not a perfect match on tenor and amount etc. In such a (normal) case, dealer has outstanding exposure to be hedged. They hedge by buying (selling also?) Eurodollar futures or trading gov bonds with repo.

In summary
AQQ's Motivation to pay fixed – predictable cost
IBM's Motivation to pay floating – lower cost

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