Central Clearing of Interest Rate Swaps: a Comparison of Oerings

Rama Cont, Radu Mondescu, and Yuhua Yu

March 11, 2011

Abstract
Regulatory changes have motivated the development of a variety of solutions for the clearing of interest rate swaps. Margin payments associated with clearing lead to modications in cash ows which result in dierences in the valuation between cleared and non-cleared swaps. two types of modications in contract value: We propose a framework for computing these dierences and show that they lead to a convexity eect and a Net Present Value" (NPV) eect, which can be signicant for long-dated swaps. As a result, modications in contract design are required in order for a centrally cleared interest rate swap to be economically equivalent to its uncleared counterpart. Among the currently available oerings for cleared interest rate swaps, three oerings are shown to be economically equivalent to their uncleared counterparts  the Price Alignment Interest method used by LCH.Clearnet and CME, as well as a new adjustment method used by the Eris Exchange  while a fourth method, used in the IDCG swap futures contract, is shown to lead to substantial deviations in valuation with respect to a non-cleared interest rate swap. Using a Hull-White model calibrated to the market data as of December 2010, we nd the dierence between the IDCG futures swap rate and the corresponding uncleared swap rate to be around 18 basis points for a 10 year contract and about 60 basis points for a 30 year contract. An interest rate environment with higher volatility will result in larger dierences.

IEOR

Dept.

Columbia

University

&

CNRS-

Universit

de

Paris

VI

(Rama.Cont@columbia.edu)

DRW Trading Group (rmondescu@drw.com). DRW Trading Group is one of the founders
of Eris Exchange and, through one of its aliates, is an investor in Eris Exchange.

DRW Trading Group (yyu@drw.com)

Electronic copy available at: http://ssrn.com/abstract=1783798

Contents
1 Introduction 2 Cleared versus Uncleared Interest Rate Swaps
2.1 2.2 Background . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Convexity and the NPV Eect . . . . . . . . . . . . . . . . . . .

2 4
4 5

3 Cleared Interest Rate Swaps Oerings 4 Example: Pricing of IDCG Interest Rate Swap Futures 5 Estimating the Fair Value of IDCG Swap Futures
5.1 5.2 5.3 Valuation Set-up . . . . . . . . . . . . . . . . . . . . . . . . . . . Valuation under the Hull-White Model . . . . . . . . . . . . . . . Numerical Results and Remarks 5.3.1 5.3.2 5.4 . . . . . . . . . . . . . . . . . .

7 9 13
13 15 17 17 18 20

Fair Value . . . . . . . . . . . . . . . . . . . . . . . . . . . Convexity Correction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Market adjustments since January 2011

6 Eris Interest Rate Swap Futures Contract 7 Conclusion

21 24

1 Introduction
The Financial Crisis of 2008 highlighted the counterparty risk associated with bilateral trading of over the counter (OTC) derivatives, even when the institutions involved are large banks. Institutions once considered infallible were Recognizing the unable to meet their nancial obligations during the crisis.

systemic risks that uncleared derivatives can create, the Dodd-Frank Financial Reform Act has mandated that derivatives transactions be cleared through central counterparties whenever possible. With more than $300 trillion of notional exchanging hands in 2009, the interest rate swap market is by far the largest OTC derivatives market. Regulatory incentives have motivated the development of dierent solutions for the central

Electronic copy available at: http://ssrn.com/abstract=1783798

clearing of interest rate swaps; exchanges and clearing houses have oered nancial products which they hope to see replace traditional uncleared interest rate swaps[Avellaneda & Cont (2010)]. Many end-users of interest rate swaps trade these derivatives as hedging instruments to reduce their exposure to interest rate risk and benet from the corresponding hedge osets under FAS 133 accounting rules [Avellaneda & Cont (2010)]. It is therefore important to examine whether the new contract designs are economically equivalent to plain vanilla interest rate swaps and will result in the hedging benets expected by the end user. Central clearing requires the daily exchange of collateral and margin payments. Ironically, this daily exchange of funds results in dierences in cash ows between a cleared instrument and an otherwise identical uncleared one. Several recent studies [Johannes & Sundaresan (2007), Fujii et al (2010), Piterbarg (2010)] have shown that these modications in cash ows have non-negligible impact on the value and sensitivity of nancial instruments. Furthermore, dierent contract designs of cleared interest rate swaps lead to dierent valuations, some of which fail to be economically equivalent to the plain uncleared interest rate swap. In the present work we examine the available oerings of cleared interest rate swaps and the implications on valuation. We propose a framework for quantifying the dierences in valuations resulting from margin and collateral payments and show that they lead to two types of modications in contract value: a convexity eect and an  NPV" eect, both of which can be signicant. have a material impact on pricing. We focus on four currently available solutions for cleared interest rate swaps: the IDCG swap future, the Price Alignment Interest (PAI) method used by LCH Clearnet, a similar framework used by the CME and the swap future contract listed on Eris Exchange. While the Eris and PAI contract designs are shown to be economically equivalent to an uncleared interest rate swap, the IDCG swap futures contract is shown to exhibit substantial deviations in valuation with respect to an uncleared interest rate swap. Using a one-factor Hull-White model calibrated to the current market environment, we nd the dierence between the par rate of an IDCG futures contract and the corresponding uncleared swap rate to be around 18 basis points for a 10 year contract and about 60 basis points for a 30 year contract. These examples show that care must be taken in designing clearing mechanisms so as to ensure that the cleared instruments remain economically equivalent to the corresponding uncleared variety. We will show that these dierences, primarily resulting from dierences in cash ows,

Outline

Section 2 reviews the inherent dierences between cleared and un-

cleared nancial instruments, with an emphasis on interest rate swaps. Current solutions for central clearing of interest rate swaps are discussed in Section 3. Three of the oerings, those of LCH.Clearnet (LCH), CME Group(CME), and

Eris Exchange (Eris), while fundamentally dierent from one another, are shown to be economically equivalent to uncleared interest rate swaps. A fourth, the swap futures contract proposed by International Derivatives Clearing Group (IDCG), is not. Section 4 presents an example of pricing the IDCG futures contract and demonstrates how it diers from an uncleared interest rate swap. Analytical and numerical results are presented in Section 5. Section 6 explains the methodology proposed by Eris Exchange that addresses the dierences between cleared and uncleared interest rate swaps. Section 7 concludes.

2 Cleared versus Uncleared Interest Rate Swaps

2.1 Background
In OTC derivatives transactions, there is no independent guarantor of performance and each party is exposed to the credit risk of its counterparty. If the transaction is a 10-year interest rate swap, for example, that credit risk continues for a substantial period of time unless the transaction is terminated early. We use the term uncleared rather than bilateral , or over-the-counter (OTC) because bilateral or OTC transactions are increasingly privately negotiated with the intent to submit them to a clearinghouse. any ambiguity. Uncleared derivatives are generally transacted pursuant to an ISDA Master Agreement (ISDA Agreement) The term uncleared removes

1 between counterparties. ISDA Agreements tend

to be heavily negotiated, and the specic terms of ISDA Agreements may vary greatly from counterparty to counterparty. Most uncleared interest rate swaps are collateralized according to the ISDA Agreement standard framework which usually includes provisions for the transfer of variation margin (also known as collateral ). Some ISDA Agreements further require that one party must post initial margin (also known as independent amount ) upon the initiation of a transaction. This is intended to give the more creditworthy counterparty comfort that the posting party will be able to perform its obligations. When initial margin is required and cash is posted, the posting party receives interest on the funds at some negotiated rate. In the OTC case, collateral, generally consisting of cash or direct obligations of the U.S. Treasury or G7 sovereigns (i.e. bills, notes or bonds), is posted by the party that has a marked-to-market loss on a transaction. Collateral ows between the parties on a regular basis (as often as daily) based on changes in the value of the position.

2 The party posting collateral continues to earn interest,

1 The

International Swaps and Derivatives Association ( www.isda.org ) is a trade associa-

tion of parties engaged in OTC trading. ISDA created the standardized ISDA Agreement to govern OTC derivatives transactions between parties.

2 Often,

there is a minimum transfer amount in an ISDA Agreement such that collateral is

only transferred if a change in the value of a transaction exceeds a dened amount.

in the case of cash, and have the right to the coupons generated, as well as the gains and losses from any changes in market value, when a Treasury obligation or other nancial instrument is posted. In the case of a cleared nancial instrument, the parties novate their trade to a central counterparty (CCP) and cease to be direct counterparties [Due et al (2010)]. The clearing house stands in the place of the parties to a trade, and each party looks solely to the clearing house for performance. Upon the initiation of a cleared transaction, both parties must post a set amount of initial margin with the clearing house. This initial margin is treated similarly to initial margin for an uncleared transaction, although parties are required to post it regardless of their creditworthiness. As in the uncleared example, the posting party earns interest on initial margin. Other than possibly increasing the cash needed to transact, initial margin should have no material impact on pricing of cleared instruments relative to uncleared instruments. The other type of margin associated with cleared transactions is variation margin, which ows daily based on marked-to-market value changes of a position. Except for one critical dierence, variation margin is similar to the concept of collateral in an uncleared transaction. This dierence between variation margin in a cleared transaction and collateral in an uncleared transaction is subtle. In both cases, cash (or other assets) move on a daily basis from one party to the other as the marked-to-market value of the position changes. In the cleared case, if a party receives variation margin, those funds are the property of that party and may be withdrawn from the clearing house. Conversely, in uncleared nancial transactions, the party posting collateral maintains ownership of the assets and receives interest on or coupons attributable to the posted assets. This subtle distinction causes a material dierence in the pricing of a cleared and an uncleared instrument with similar terms.

2.2 Convexity and the NPV Eect

We will now discuss in detail why the dierence in the treatment of variation margin (cleared scenario) and collateral (uncleared scenario) results in substantially dierent economics between cleared and uncleared nancial instruments. The nature of these dierences may be broken into two types, consisting of a fairly well-understood eect, commonly known as a convexity eect , and a further eect we will refer to as the Net Present value (NPV) eect . A convexity eect appears in futures contracts when there is a signicant correlation between the price of the future and the term rate which corresponds to the expiry of the future. Take the example of a short position in a Eurodollar futures contract. The nal settlement value for Eurodollar futures is equal to 100 minus the 3-month LIBOR rate. Therefore, as interest rates rise, the price of Eurodollar futures decline. Assume that shortly after establishing the position, the trade becomes protable on a marked-to-market basis due to an increase in interest rates. As a result, the party receives variation margin in the

form of cash equal to the prot. The party could now use this cash to purchase a zero-coupon Treasury bond. Now assume that interest rates decline and Eurodollar futures return to the same price at which the trade was initiated. The party holding this position now pays variation margin in an amount equal to the variation margin it received upon the increase in interest rates. The result is that the party has no prot or loss on its Eurodollar futures position; however, because interest rates are now lower than when the zero-coupon bond was purchased, the party will realize a prot on the zero-coupon bond. Hence, there is a clear benet to being short Eurodollar futures because of the positive correlation between such futures and xed-income instruments in general. forward rate agreements (FRAs). The same is true with respect to interest rate swaps. Due to the high correlation between the value of an interest rate swap and interest rates, the convexity eect is highly relevant in determining the value of cleared interest rate swaps. Like the EurodollarFRA example above, a cleared interest rate swap will trade at a dierent price from its uncleared interest rate swap counterpart as a result of the convexity eect. But the convexity eect is not the only factor that causes a dierence in the pricing of a cleared and uncleared interest rate swap. The second eect that results from the dierence between variation margin on a cleared nancial instrument and collateral on an uncleared nancial instrument is the NPV eect . While the NPV eect and the convexity eect are intertwined, nancial instruments that have no correlation to the level of interest rates and hence no convexity eect, still will be subject to the NPV eect. The following example illustrates the NPV eect. Assume that a party to a As a result, Eurodollar futures trade at higher yields (lower prices) than their corresponding uncleared instruments,

10-year, natural gas swap makes xed monthly payments of $4 (the buyer of the swap), and receives oating payments equal to the spot price of natural gas from a counterparty (the seller). Because this is a 10-year swap, these payments continue for 120 consecutive months. Assume further that on the date the swap was created, the 10-year, natural-gas forward curve is at at $4. Therefore, the swap requires no upfront payment. On the day after the parties enter into the swap, the 10-year, natural-gas forward curve moves to a at $5. At that point, the buyer expects to receive $1 every month for the next 10 years, or $120 over the next 10 years. The net present value of these cash ows, assuming a 6.0% annual interest rate, is approximately $90. In the case of an uncleared natural-gas swap, the buyer receives $90, the net present value of the future cash ows, as collateral from the seller. If the buyer unwinds the trade by selling the swap to a third party for fair value, an upfront payment of $90 will be made to the original buyer, and the $90 collateral will be transferred to the third party. The original buyer has thus realized a prot of $90 and has liquidated its position. Now consider the same natural-gas swap but assume it is cleared and has no adjustments for the NPV eect. When the natural-gas forward curve moves

to $5, the fair value settlement price of the cleared swap is $120, the sum of its future cash ows. Futures, by arbitrage-free principles, trade at their future value. Therefore, the buyer receives $120 of variation margin today, as opposed to $90 in the uncleared case. The buyer could now exit or hedge o the cleared position, and would be materially better o than in the case of a similar uncleared natural gas swap. This is the NPV eect.

If this cleared natural-gas swap is settled at the NPV, $90, then the buyer will only realize a prot of $90 today. Assuming the natural-gas curve and the interest rate remain the same for the next 10 years, the buyer will realize the rest of the prot, $30, over the next 10 years. Therefore the fair value of the contract, dened as the amount that the buyer will demand to unwind the position today, is the present value of $30 (approximately equal to $25 with 6.0% interest rate), in addition to the current settlement price, $90.

3 Cleared Interest Rate Swaps Oerings

In response to regulatory incentives for migrating OTC derivatives to a central clearing, exchanges and clearing houses have developed cleared interest rate swap products. We will briey discuss four oerings, by LCH.Clearnet (LCH), CME Group, Eris Exchange (Eris) and International Derivatives Clearing Group (IDCG).

LCH - SwapClear
LCH.Clearnet (LCH) is an independent clearing house serving major international exchanges and platforms, as well as a range of OTC markets.

4 Through

its SwapClear facility, LCH clears interest rate swaps. Counterparties initially enter into a bilateral interest rate swap and subsequently submit the interest rate swap to SwapClear for clearing. Upon acceptance by LCH, the parties to the trade no longer have any exposure to each other. Rather, the parties look solely to LCH for performance. LCH's interest rate swaps oering has addressed the convexity and the NPV eect through the introduction of Price Alignment Interest (PAI). LCH credits or debits to each open position on a daily basis to oset the benet of being able to invest the variation margin . Recall that in an uncleared transaction,

3 Note that as interest rates 4 LCH.Clearnet Group,

(accessed Feb. 15, 2011).

About Us

approach zero, the NPV eect is eliminated. (available at http://www.lchclearnet.com/about_us/)

5 [LCH

Rule 3.5.2 (Price alignment Interest (PAI) Rate) states in part:

To minimize the impact of daily cash variation margin payments on the pricing of interest rate swaps, the Clearing House will charge interest on cumulative variation margin received by the clearing member and pay interest on cumulative variation margin paid in by the clearing member [in] respect of these instruments. This interest element is known as price alignment interest (PAI). LCH Rule 3.5.2.

the party posting cash collateral continues to earn interest. LCH uses PAI to replicate this interest payment and generates the same cash ows as an uncleared swap. The PAI rate is set at the Eective Federal Funds rate for U.S. Dollar denominated interest rate swaps.

Implementing the PAI solution into the current futures system could be cumbersome for clearing rms and end users, because a separate computation of the interest on accumulated variation margins is required. For instance, Sungard's GMI system requires the use of a new module for such computations.

CME Group
CME is the dominant exchange holding company in the United States. It has launched a cleared only interest rate swap facility. The oering seems to be very similar to the SwapClear products, and does include a PAI adjustment. Unlike traditional futures, the CME oering will be in a separate OTC segregated account type.

Eris interest rate swap futures

Another solution for cleared interest rate swaps is based on swap futures contracts. Such contracts are listed on the Eris Exchange, an exempt board of trade, whose trades are cleared and processed by the CME's clearing house. The Eris contract uses a patent pending methodology to address both the convexity eect and the NPV eect by incorporating an adjustment to the terminal

value of the futures contract.

7 The starting point of the Eris swap futures con-

tract is to consider a plain interest rate swap and dene the terminal value of the contract as the dierence between:

the accumulated value of payments made pursuant to the terms of the swap; and the accumulated value of interest earned on variation margin over the life of the futures contract.

As we will see in Section 6, this solution ensures that Eris's futures contracts are economically equivalent to their uncleared counterparts. Implementation of the Eris terminal value methodology is substantially dierent from LCH's PAI solution. Because Eris's futures contracts are adjusted only through their terminal value, rather than by a daily cash adjustment, it can be added to existing futures clearing systems relatively seamlessly without requiring expensive modications.

6 LCH 7 The

Rule 3.5.2. contract specications may be found at Eris Exchange website

(http://www.erisweb.com).

IDCG
IDCG has both a clearing house, International Derivatives Clearinghouse (IDCH), and an exchange, International Derivatives Exchange (IDEX). IDEX lists U.S. Dollar denominated swap future contracts. IDCG also accepts traditional bilaterally negotiated swaps for clearing. Its clearing house, IDCH, uses an exchange of futures for swaps (EFS) to convert an interest rate swap into one of its futures contracts. IDCG also oers a clearing facility for (regular) interest rate swaps , which deploys a PAI adjustment that is not used with the IDCG futures contract. This paper focuses solely on the IDCG futures contract, where there is no adjustment for the convexity and NPV eects. There are two important features of the IDCG futures contract:

As with a standard interest rate swap, periodic coupon payments are made on a semi-annual basis for the xed rate payments, and on a quarterly basis for the oating rate payments.

As with any cleared futures contract, variation margin on open positions is computed and ows daily, based on the NPV of the relevant swap and a discount curve that is constructed by LIBOR deposit rates, FRA's and swap rates.

IDCG claims that its futures contracts are economically equivalent

9 to un-

cleared swaps with similar terms. We will see, however, that the design of the IDCG futures contract does not address the convexity eect nor the NPV effect; as a result, it leads to substantial dierences in valuation compared to an uncleared swap.

4 Example: Pricing of IDCG Interest Rate Swap Futures

In this Section, we will consider the pricing of an IDCG 10-year swap futures contract. We will show that due to the convexity and the NPV eects the IDCG futures contract is not economically equivalent to a 10-year uncleared interest rate swap. The arbitrage-free value of an uncleared swap position is equal to the expected sum of its discounted cash ows, with respect to a pricing measure. We refer to

8 Rule
Clearinghouse,

Self-Certication LLC (Nov.

of

the 10,

International 2010),

Derivatives available at

http://cftc.gov/stellent/groups/public/@rulesandproducts/documents/ifdocs/rul111010idch001.pdf.

9 International

Derivatives Clearing House (http://www.idcg.com/idch/index.html) (ac-

cessed Feb. 15, 2011).

this quantity as the NPV. For purposes of this discussion, assume the NPV of an uncleared swap is computed using the following yield curve Fig. 1 which has been constructed from deposit and swap rates using a bootstrapping methodology:

Figure 1: zero curve at initial time The par swap rate

10 for a 10-year uncleared interest rate swap is 2.820% based on

the assumed yield curve in Fig. 1. Setting the notional value at $1,000,000, the projected netted (xed minus oating) coupon payments from the perspective of the receiver are shown graphically versus time in years in Fig. 2. To fully understand Fig. 2, it is important to note that xed payments are made semi-annually, and oating payments are made quarterly under a vanilla interest rate swap. Thus, every other quarter only a oating payment is made. In such quarters, there is no netting . For purposes of this example, consider the special case where yield curve volatility is zero, meaning that the yield curve used to price the contract upon inception of the transaction accurately predicts interest rates at future dates. Fig. 3 shows the NPV of this interest rate swap to the receiver as a function of time in years with this static yield curve assumption. The oscillations result from the periodic coupon payments. The shape of the graph is convex because the xed payments exceed the oating payments for the rst ve years of the swap. Thereafter, the oating payments exceed the xed payments. The negative values in Fig. 3 represent the NPV to the receiver. However, the receiver in this swap actually has a P&L of $0 as the net cash ows oset the negative NPV.

10 The

par swap is the xed rate at which, given a particular yield curve, the swap has a

value of 0 to either the payer or the receiver.

10

Figure 2: swap coupon cash ows

Figure 3: Evolution of the NPV for a 10-year swap.

Since rate volatility is assumed to be zero, we can use the NPV graph of Fig. 3 to predict the daily value for this interest rate swap for its entire term and the daily price changes. If this were a cleared IDCG futures contract, these daily price changes will result in variation margin owing to either to or from the receiver.

11

The sum of these daily cash ows, together with the periodic coupon payments set out in Fig. 2, yields the total accumulated cash ow generated by the IDCG futures contract at any point in time. These total accumulated cash ows over

11 Note

that the payer will have exactly the opposite cash ows from variation margin.

11

the life of the IDCG futures contract are shown in Fig. 4.

Figure 4: Accumulated cash ows of an IDCG swap. The discounted present value of this stream of cash ows is the economic difference between an uncleared swap contract and the IDCG futures contract. In our example, involving a $1,000,000 notional 10-year vanilla interest rate swap, the discounted present value of the accumulated cash ows between initiation and maturity, is -$10,768. In other words, the receiver is worse o by $10,768 if it trades the IDCG swap future rather than an uncleared interest rate swap.

1213

In our example, there is an interest rate at which two parties should be willing to trade the IDCG futures contracts and have an expected P&L of zero for both parties. This interest rate, however, is not the same as the par coupon rate of the corresponding uncleared interest rate swap. We dene such a rate as the

fair rate of an IDCG futures contract (or equivalently, the fair coupon ). In the
current example, the fair rate is 2.93% because, on one hand, the value of the 10-year 2.93% IDCG futures contracts is -$9,900 to the receiver applying the same analysis as above; on the other hand, the receiver has a positive variation margin cash ow on the day of the transaction with the amount equal to the dierence between the settlement price and the traded price, or $9,900 (the NPV of an uncleared swap) in this example. Given that the uncleared swap has par rate 2.82%, the dierence between the fair rate of a 10-year IDCG futures contract and a 10-year uncleared swap par coupon is 11 basis points. Furthermore, it is important to note that in this simple example, we have held volatility of interest rates at zero and have thus primarily isolated the NPV eect. Holding interest rate volatility at zero eliminates the convexity eect.

12 And conversely, the payer is better o by $10,768. 13 Our analysis excludes trading and other fees.

12

If interest rate volatility were added to the analysis, the convexity eect would increase the dierence between the IDCG cleared contract and its uncleared counterpart. This eect is investigated in detail in the next two sections.

5 Estimating the Fair Value of IDCG Swap Futures

5.1 Valuation Set-up
The cash ows generated from the IDCG futures contract have three components. The rst component is the cash ows from the daily variation margin based on the change in the NPV of an uncleared interest rate swap. Let NPV of a unit notional (N0 with maturity and

Ft

denote the ...,

= 1),

receiver interest rate swap starting at

T1 ,T2 , (f l) (f l ) (f l) quarterly oating coupons payable at times T1 ,T2 ,...,TM : M N ( f l) ( f l) Tj 1 ,Tj 1 1 j , BTi C i B ( f l) L Ft = Et Tj Ti >t ( f l)
semi-annual coupon rate payable at times

T,

T0 , TN ,

(1)

Tj

>t

where

is the time between the xed payments,j the accrual periods of each

oating payments and

LTj1 ,Tj

(f l)

(f l)

the forward rate xed at time

notes the expectation conditional on the information up to risk neutral measure with the money market account

Tj 1 . Et time t, under

(f l)

dethe

Bt

as the numeraire. Note

that for an uncleared vanilla swap both payment legs have the same maturity

TN = TM

(f l)

T Let Pt be the price at time t of a zero coupon bond maturing at time for t T0 the above can be calculated as N

T,

then

Ft = C
i=1

PtTi i PtT0 + Pt

TM

( f l)

If the swap is seasoned (e.g., the swap started in the past and the next oating payment occurring at

TS

(f l)

has been xed),

Ft

becomes

Ft = C
Ti >t
where the index

PtTi i (1 + LTS1 ,TS S )Pt

satises

( f l)

(f l)

TS

(f l)

+ Pt

TM

(f l)

TS 1 < t TS
13

(f l)

(f l )

Ft

can be thought of as the price of an asset that pays discrete dividends. On

the day of coupon payment, of the coupon. and

Ft has an instantaneous jump equal to the amount Ft Ft = C i , if t corresponds to a xed payment time Ti ,
(f l) ( f l)

Ft Ft = LTj1 ,Tj

j ,

if

corresponds to a oating payment time

Tj

(f l )

The second component in the cash ows is generated by the coupon payments (net of xed and oating). At each time of the xed coupon payment

Ti , the (f l) amount is equal to C i , and at each time of the oating coupon payment Tj ,
the amount is equal to equal to

LTj1 ,Tj

( f l)

( f l)

j .

The present value of this component is

F0 .

The third component only occurs on the day when the trade is consummated. If the coupon of the swap does not coincide with the swap rate on the settlement curve, a positive or negative cash ow equal to the initial settlement price, applies through the variation margin. The value of the IDCG futures contract can be computed as the sum of the expected present value of these three cash ows under the risk neutral measure. The value at the time of trade initiation is

F0 ,

V0 =
ti T

1 E Bt (Fti Fti1 ) + F0 + F0 , i

where the summation is calculated over each trading day through the expiration, and we omit the subscript in

E0

here.

The continuous-time analogue of this

expression is [Norberg & Steensen]:

V0 = E{
0
Since

T 1 Bs dFs } + 2F0

Bt

satises

dBt = rt Bt dt,

with

rt

integration by parts and using the fact that

E{

1 1 } F0 B 0 r F B 1 ds} + E{FT BT 0 s s s 14 the value can be written as

the short rate at time t, applying T 1 FT = 0, we obtain E{ 0 Bs dFs } = T 1 = E{ 0 rs Fs Bs ds} F0 . Therefore

V0 = E{
0

T 1 rs Fs Bs ds} + F0 .
(2)

In the case of zero volatility, deterministic short rate case presented in Section 4, the value can be calculated explicitly as quantities

V0 =

T
0

1 rs Fs Bs ds + F0 ,

where all

rs, Fs

and

Bs

are deterministic.

In the general case and for a certain choice of interest rate model, the value of the IDCG futures contract.

V0 can be com-

puted by simulation. In some simple cases, one can also estimate analytically

14 The
there for

value of a seasoned IDCG swap does not include the initial variation margin, and

T 1 ds}, t > 0. Vt = E{ 0 rs Fs Bs

14

5.2 Valuation under the Hull-White Model

To quantify the dierent features of the IDCG futures contract, we consider the Hull-White extension of the Vasicek model with time-dependent parameters [Brigo & Mercurio] which assumes the following dynamics for the spot rate under the pricing measure:

drt = ((t) art )dt + dWt ,

where

(t)

is the long-term mean of the short-rate (allowing exact calibration

to the initial yield curve), and and volatility, respectively.

and

the short-rate mean-reversion speed

In the limit

a 0

the model reduces to the Ho-

Lee model with time-dependent drift term, a simplied scenario we use later to illustrate the main aspects of the computation. Although the model has well known limitations in describing the more complex dynamics of the interest rates observed in the market (see [Brigo & Mercurio], for example, for more discussions and alternative model choices), its analytical properties give simple insights into the dependence of the eects discussed above. Noting that the value

Ft

of the NPV of an uncleared interest rate swap from

Eq. (1) is a sum of the NPV's of each coupon payment, a xed coupon payment value of this payment is

V0

given by Eq. (2) is

subsequently a sum of the contribution of each payment. Let

V0i

correspond to

C i

occurring at

Ti .

Based on the formula of the value

of the IDCG futures contract from above and applying a measure change, the

V0i =
0

Ti

Ti Ti 1 E{rs C i Ps Bs }ds + C i P0

=
where

Ti C i P0

Ti

Ti dsETi {rs } + C i P0 .

Ti

denote the expectation under the risk neutral measure with zero

coupon bond

PtTi

as the numeraire. Within the Hull-White model the previous

expectation can be calculated exactly as

Ti V0i = C i P0

2 e2aTi 4eaTi + 3e2aTi + 1 2 Ti + Ti RTi + 1 4a3 2a2

(3)

Examining the case where the mean reversion eect is small allows a better understanding of the eect of the volatility: taking we obtain

a 0 in the above expression

1 Ti (4) V0i C i P0 (RTi Ti 2 Ti3 + 1), 6 Ti RTi Ti where RTi is the continuously compounded zero-rate to Ti , i.e.. P0 = e . i The dierence between V0 and the regular NPV price of the xed coupon payTi ment C i P0 is measured by the factor in parenthesis minus 1. There are two
15

components in the dierence: the rst term is the deterministic rates case contribution

RTi Ti , and the second term indicates the eect of a non-zero volatility
Note that the contribution from the volatility is strongly

of the short rate. dependent on both

Ti

(the payment maturity) and volatility itself through the

3

square of the dimensionless quantity

Ti2 , typical for short-rate normal models.

Starting with the eval-

The oating side is treated in a similar manner, although the work is more involved as the payments themselves are uctuating. uation formula for

V0i,f l ,

the value of the

i-th

oating payment with maturity

Ti

(for notational convenience we omit the superscript in

Ti

(f l)

in the following

discussion) and accrual period

i = Ti Ti1 ,

we have

V0i,f l

= E{
0

Ti

1 Ti1 ,Ti rs Bs L i ds} + L0 i1

,Ti

Ti i P0 ,

(5)

where the random payment amount

LTi1 ,Ti i =

1 T PT i

is xed after time

i1

Ti1 .

The computation is carried out by splitting the time integral in two

components separated by the start of the accrual period the expression

s = Ti1 ,

resulting in

V0i,f l

Ti = P0

2 eaTi 3 2 2 Ti 2 e2aTi + 3 + Ti RTi 3 3 4a a 4a 2a2 3 2 e2aTi 2 e2aTi1 + 3 4a a3

(6)

+ P0 i1

2 eaTi1 2 eai + a3 2a3 2 e2ai 3 2 ea(Ti +Ti1 ) 3 2 2 Ti + 3 + Ti RTi 3 3 2a 2a 4a 2a2

T ,Ti Ti i P0

+ L0 i1

(7)

As in the case of xed payments, we can take the limit reversion parameter). Eq. (6) becomes

a 0

(slow mean-

Ti V0i,f l = P0 L0 i1 T ,Ti

,Ti

1 T 2i 1 i (RTi Ti 2 Ti3 + 1) + P0 i1 2 Ti2 1 i 1 6 2 Ti1 V0i

(8)

with

L0 i1

the forward rate observed today. We remark that the rst part in Eq. (4) with

of the expression is the equivalent of the xed coupon value

the payment determined by the current forward rate, and the second part is an adjustment for the fact that the actual payment is random until time

Ti1 .

Except possibly for coupons with long accrual periods starting very close to the spot date (t

=0

in our case), note that the short rate volatility has a positive

eect on the value of a oating payment (due to changes in the payment amount itself ), in contrast to the eect on the xed payment.

16

To illustrate the eect of the volatility, we now give a numerical example using formulas in Eqs. (4),(8).These results are obtained under zero mean-reversion, corresponding to the Ho-Lee model. As we show in the next section, the mean reversion calibrated under the current market environment is very small, and thus Eqs. (4),(8) represent a good approximation. Consider a stylized IDCG-type contract that has one xed and one oating payment, with dierent accrual periods but the same maturity

T.

The values

of the xed and of the oating leg are computed as in Eq. (4) and Eq. (8), respectively. The fair coupon of the IDCG futures contract is the coupon rate

in Eq. (4) that equates the initial fair valueV0

as in Eq. (2), the initial variation margin

= V0i V0i,f l amount F0 ).

to zero (including,

We dene the convexity correction of the IDCG futures contract as the dierence between its fair coupon and the par coupon of an equivalent (in terms of start date, maturity and cash ow payment dates) uncleared interest rate swap. It is worth noting that this convexity correction is a result of both the convexity eect and the NPV eect as we discussed in Section 2.2. Choosing a maturity of

T = 10 years, standard accrual periods of 0.5 and 0.25 years for the xed and

oating leg, respectively, and assuming a 3% at rate environment (continuous compounding), the par coupon (quoted with simple compounding) of an uncleared swap is approximately 1.5%, because the xed payment accrual period is twice as large as the oating side accrual period. If the short rate volatility contract is 1.6%, resulting in a convexity correction of 10 basis points. Denoting the notional value by butions,

is 74 basis points (1 basis point =0.01%) , the par coupon of the IDCG futures

N0 ,

the total fair value

V0

of a standard IDCG

futures contract is calculated by summing all the individual cash ows contri-

V0 = N0
i=1

V0i
i=1

V0i,f l

where each xed and oating payment are calculated as in Eq. (3) and Eq. (6), respectively. The full expression is more complicated in this situation and is not reported here.

5.3 Numerical Results and Remarks

5.3.1 Fair Value
Formulas Eq. (3) and Eq. (6) may be used to compute the values of some spot starting IDCG futures contracts (payer) with a notional amount of $100,000,000. The following results are based on the IDCG settlement curve as of Dec 1, 2010, and the Hull-White model parameters are calibrated on the same day to a set of caps. In the current low rate environment, the mean-reversion speed is close to

17

zero (even negative, implying expectations of increasing rates), and the volatility is in the lower end of its historical range. Maturity 5 10 30 Par Coupon 1.866 3.105 3.942 DV01 48,600 87,213 172,578

15

IDCG Settlement 0 0 0

Value (in Million) 0.22 1.85 15.57

The DV01($/basis point) we report here is for an uncleared interest rate swap. As an example of how to interpret the numbers in the table above, the 10year spot starting swap, while it settles at par on IDCG, has a fair value (for the payer) of $1.85 million. Therefore, in order to settle this swap to its fair unwinding value, the 10 year yield on the settlement curve has to increase by approximately 21 basis points(= 1,850,000/87,213).

5.3.2 Convexity Correction

In the contour plot in Fig. 5 we show recent results for the convexity correction (dened as the dierence between the fair rate of an IDCG futures contract and the par coupon of an uncleared swap with the same payment structure) of an IDCG swap starting today with a maturity of ten years, as a function of the model parameters: the short rate volatility

and the mean-reversion rate a.

We

use the discount curve that is published daily by IDCG for settlement purposes. Across the given parameters, the convexity correction (as contour lines) is positive indicating that the fair rate of an IDCG futures contract is higher than the par coupon of an uncleared swap. The red dot corresponds to the convexity correction of 18 basis points obtained recently (as of December 2010), using Hull-White model parameters calibrated as before. Qualitatively, the iso-convexity lines with positive slope illustrate the combined eects of the mean-reversion parameter and volatility. If mean-reversion speed increases, the short rate will converge faster to its long term mean. Therefore to obtain the equivalent convexity correction, the volatility parameter would need to be increased. Similar behavior emerges when we calculate the price of a longer maturity contract, such as the 30 year swap shown in Fig. 6. The 30 year convexity correction is generally higher than the correction of the 10 year contract, and increases at a much steeper rate when volatility increases, at the same mean-reversion parameter value. This behavior is driven by the model implied volatility of the forward rate, decreasing exponentially with maturity, but being linear in the volatility of the short rate.

15 Specically,

we obtain

a = 0.003, = 74

basis points.

18

IDCG Swap Maturity 10Y 200 26 22 30 Short Rate OU Vol Basis Pts 150 24 28 100 20 12 16 18 14

1 2010 18

50 12 0 0.0 0.1 0.2 0.3 0.4

1

0.5

0.6

Mean Reversion Rate years

Figure 5: Convexity correction to the par swap rate for a 10 year IDCG futures contract with respect to an uncleared swap with same characteristics.

The current convexity correction of a 30 years IDCG futures contract is about 60 basis points, indicated by the red dot inset, with an approximate lower bound of 20-30 basis points in the regime with a lower mean-reversion rate as identied by calibration. Although the pricing of the IDCG futures contract involves a choice of a term structure model and implies dependencies on various delicate calibration procedures, we note that in the current interest rate environment, the convexity correction remains large across a wide range of parameters and there is a clear lower bound (approximately 10 bps for 10 year and 20 bps for 30 year) of the dierence between an IDCG futures contract and an uncleared swap. While we can certainly improve the choice of model and extend the approach such as to a two factor Gaussian model, we do not expect that the results to change signicantly given the intrinsic structure of the IDCG futures contract.

19

IDCG Swap Maturity 30Y 200 55 40 25

Short Rate OU Vol Basis Pts

150 50 100

30 45

12 1 2010 60
35 50

20 0 0.0 0.1 0.2 0.3 0.4

1

0.5

0.6

Mean Reversion Rate years

Figure 6: Convexity correction to par spread with respect to an uncleared swap: 30 year IDCG swap future.

5.4 Market adjustments since January 2011

Since January 2011, the IDCG settlement curve has started to deviate from the LIBOR swap curve as the market place came to a better understanding of the nature of the IDCG futures contracts. On February 9, 2011, for example, the IDCG 10-year swap contracts settled 20 basis points higher than the corresponding uncleared swap, and a 30-year contract 25 basis points higher. To see whether the IDCG settlement price has converged to its proper level under the current environment we carry out the same calculation in 5.3.1 as of February 9, 2011. The model parameters futures convexity bias.

16

and

are recalibrated to the recent Eurodollar

Using the above analytical results, we compute the fair values of spot starting par IDCG futures contracts based on the LIBOR swap curve, then compare

16 Specically,

we use a set of LIBOR deposits, swaps and Eurodollar futures data as of

February 9, 2011, and obtain

a = 0.107, = 158

basis points.

20

those values with the current IDCG settlements, which are not equal to zero due to a dierent settlement curve from the LIBOR swap curve. We consider payer swaps with a notional amount of $100,000,000. Maturity 5 10 30 Par Coupon 2.524 3.687 4.440 DV01 47,598 82,506 151,466 IDCG Settlement(Million) 0.53 2.37 4.69 Value(Million) 0.50 2.73 12.78

In order to settle those swaps at fair value, the 10-year yield on the settlement curve needs to increase by approximately 4 basis points (=(2.73-2.37)*1,000,000/82,506) and the 30-year yield needs to increase by approximately 53 basis points. It is worth noting that, even if the settlement curve moves to a level that settles the above spot-starting swaps at fair value, it cannot settle all the seasoned swap contracts to the proper levels simultaneously. For example, if a spot starting 10year swap contract was traded on December 1, 2010 with a par coupon of 3.105%, it will settle at $4.26 million with a fair value of $3.30 million on a LIBOR swap curve. Given the current IDCG settlement curve, the settlement price of this seasoned contract will be $6.45 million, and the DV01 equal to $78,579 per basis point. Therefore, the 10-year yield on the settlement curve needs to further increase by 14 basis points (=(3.30-(6.45-4.26))*1,000,000/78,579) in order to settle this seasoned contract at its unwinding price. As the marketplace comes to understand the nature of the IDCG futures contract, transactions at the fair rates will dominate the trading of the IDCG futures contracts, and therefore move the IDCG settlement curve higher. The new settlement curve will then result in dierent fair rates. The natural question to ask is whether the fair rates and the settlement curve will eventually converge. We believe the answer is yes, and we call the resulting curve the fair settlement

curve. Under the fair settlement curve, swaps with the fair rates are settled at
par and have values equal to 0. With the same model parameters as of February 9, 2011, we compute the 10-year swap rate from the fair settlement curve should be 30 basis points higher than the corresponding uncleared swap rate, and around 70 basis point higher for the 30-year swap. For details about this calculation, we refer the readers to a companion paper [Mondescu et al (2011)].

6 Eris Interest Rate Swap Futures Contract

Eris uses an original methodology to address both the convexity eect and the NPV eect by incorporating an adjustment to the terminal value of its futures contract. The starting point of Eris swap futures contract is to consider a plain interest rate swap and dene the terminal value of the contract as the dierence between

accumulated value of payments made pursuant to the terms of the swap, and

21

the accumulated value of interest earned on variation margin over the life of the futures contract.

We will now show this adjustment makes the Eris futures contract economically equivalent to an uncleared interest rate swap. Let

St

denotes the daily settlement of an Eris swap futures contract.

using our previous notations the terminal value can be expressed as

1718

Then,

M 1 BT C i i

ST = BT (
i=1

j =1

Tj 1 ,Tj B (1 f l) L Tj

(f l)

(f l)

j
0

T 1 rt Bt St dt).
(9)

To simplify the notations, we use

Ci

and

Ti

to denote the amount and time, We can rewrite the above

respectively, of both xed and oating payments. expression and apply integration by parts:

1 BT Ci i 0

T 1 rt Bt St dt)}

ST

BT (
i=1 N

1 BT Ci + i 0

T 1 St dBt )

BT (
i=1 N

1 BT Ci i

T 1 Bt dSt )

BT
i=1 N

1 BT (ST BT

S0
0

1 BT Ci i

T 1 Bt dSt .

BT
i=1

+ X BT S0 BT
0

Rearranging the terms and dividing both sides by

BT ,

we obtain

S0 +
0

T 1 Bu dSu =

N 1 BT Ci . i i=1
(10)

Take expectations on both sides, recalling that the futures price tingale and

St

is a mar-

E0 {

Ft denotes N 1 i=1 BTi Ci } = F0 .

the NPV of the interest rate swap, we have

S0 =

Therefore the initial futures price is equal to the NPV

of the interest rate swap. We can further derive the futures price at any time expectation of Eqs. (10) with respect to time

t,

by taking the conditional

t:

17 Eris 18 The

adds a constant of 100 to the terminal value. This is due to a legacy restriction that calculation implemented by Eris discretizes the integral in the terminal value using

futures price must be positive. We drop this constant here as it does not aect our analysis. a one-day time step.

22

 S0 +
0

t 1 Bu dSu =

N 1 BT Ci + Et { i Ti t

N 1 BT Ci }. i Ti t
(11)

Applying integration by parts to the left hand side:

1 LHS = S0 + St Bt t t N 1 1 1 1 1 S0 B0 + 0 ru Bu Su du = St Bt + 0 ru Bu Su du. On the other hand, Et { Ti t BT Ci } i N 1 1 1 Bt Et { Ti t Bt BTi Ci } = Bt Ft . Eqs. (11) becomes:

1 St Bt + 0

t 1 1 ru Bu Su du = Bt (

N 1 Bt BT C i + Ft ) . i Ti t

Multiplying both sides by

Bt ,

we obtain

1 Bt BT Ci i

t 1 ru Bu Su du.
(12)

St =
Ti t

+ Ft Bt
0

Eqs. (12) is used to calculate the daily settlement with the discretized version of the integral. The rst term is the accumulated value of all realized coupon payments up to time

t.

The second term is the NPV (of the remaining cash

ows) of the interest rate swap. The last term, so called total return on modied

variation margin

19  , represents the adjustment of all the interest earned on the

variation margin cash ows to date. To see that the Eris future generates the same prot and loss as its uncleared counterpart, rearranging the terms in Eqs. (11), we have

1 BT Ci + i N N 1 1 1 Et { Ti t BTi Ci } S0 = Ti t BTi Ci + Bt Ft S0 . The left hand side is the present value of the prot (or loss) of a party who enters the Eris swap future 0 1 Bu dSu =
at time

N Ti t

and closes the position at time

t.

The right hand side represents the

present value of the coupon payments of the interest rate swap up to time plus the NPV at time

t, t discounted to time 0, minus the initial value of the swap. 0

and liquidates the

Therefore, the right hand side is the present value of the prot (or loss) of a party who enters the uncleared interest rate swap at time trade at time

t.

Comparing the daily settlement calculation for the Eris future versus the IDCG future, there are two additional terms in the Eris future. The rst term captures the realized coupons because, unlike IDCG, Eris does not require separate coupon cash ows. The second term, total return on modied variation mar-

gin, makes a futures contract, where prot and loss are immediately realized,
equivalent to an uncleared contract where prot and loss are only realized at termination. This term is comparable to the PAI implemented by LCH. However, as we have shown above, the adjustment in the Eris swap futures is derived from the risk neutral valuation when the terminal value of the futures contract

19 The

variation margin is equal to

Su S0

23

is properly dened and therefore part of the settlement price. LCH, on the other hand, imposes the adjustment as a separate cash ow.

7 Conclusion
As OTC derivatives transition to central clearing, care must be taken to address the changes in valuation resulting from cash ows related to collateral requirements and margin payments. We have shown that, even in the case of an instrument as simple as an interest rate swap, these cash ows can have a substantial impact on valuation. IDCG's interest rate swap futures contract does not address the important contribution of the eects of the variation margin cash ows. Our study shows that the 10-year IDCG futures contract should trade at a fair rate approximately 18 basis points higher than the par rate of an otherwise identical uncleared swap. The PAI solution, rst implemented at LCH and also adopted by CME, addresses the convexity and NPV eects. However the PAI solution does not t neatly into current futures systems. A more elegant solution to the problem of clearing an interest rate swap is Eris's original methodology. The Eris swap futures contract incorporates both the convexity as well as the NPV eect directly into its terminal value. relatively seamlessly. This enhancement means that the Eris contract can be added to existing futures clearing systems

References
[Avellaneda & Cont (2010)] Avellaneda, M. and Cont, R., Transparency in Interest Rate Derivatives, Working paper, 2010. [Brigo & Mercurio] Brigo, D. and Mercurio, F., Interest Rate Models - Theory and Practice, Springer, 2007. [Due et al (2010)] Due, D., Li, A. and Lubke, T., Policy perspectives on OTC derivatives market infrastructure, Working Paper 2010-002, Milton Friedman Institute, 2010. [Fujii et al (2010)] Fujii, M., Shimada, Y. and Takahashi, A., A Note on Construction of Multiple Swap Curves with and without Collateral, Working Paper, Tokyo University, 2010. [Mondescu et al (2011)] Mondescu, R., Wilson, J. and Yu, Y, Central clearing of interest rate swaps: a comparison of dierent proposals - Part II, Working Paper, 2011. [Piterbarg (2010)] Piterbarg, V., Funding beyond discounting: collateral agreements and derivatives pricing, RISK, March 2010, 97102.

24

[Johannes & Sundaresan (2007)] Johannes, M. and Sundaresan, S., Pricing collateralized swaps, Journal of Finance, 62, pages 383 410, 2007. [Norberg & Steensen] Norberg, R. and Steensen, M., What is the Time Value of a Stream of Investments? J. Appl. Prob. 42, 861-866, 2005.

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