Converting Swaps into Futures
“Regulators win as ICE converts swaps to futures” – read the Thompson Reuters Westlaw’s headline on Aug 6. The Intercontinental Exchange (ICE) had announced that all its over-the-counter (OTC) cleared energy swaps would be converted to futures contracts from January 2013. A “cleared swap” is a term introduced in 2009 as part of an effort to standardise the OTC derivatives in order to bring them on to exchanges, and be subjected to markto-market and margining rules. Cleared swaps are swaps that are traded and settled with the exchanges. Hence, when a party enters a cleared swap, the other side of the trade is the Exchange. Once a standardised swap trades on the exchange, they quite resemble futures. In this article, I show how a swap can be converted into futures. The trade is chosen from one of the trades published by the CFTC (the U.S. Commodity Futures Trading Commission) in the U.S. Federal Register in Nov 2010. The Swap We have a fixed for floating WTI (West Texas Intermediate) Crude Oil swap with features shown in Table 1. This swap will have cash flows as shown in Chart 1, with Party A paying a fixed rate of $80 per barrel for 100,000 barrels every month and receiving the floating rate for 100,000 barrels each month. The floating rate is the settlement rate of the one-month futures expiring on the 22nd of the preceding month. Table 1
Notional Quantity Fixed Price Floating Price Calculation period Settlement type Swap term 100,000 barrels a month $80 per barrel Daily official next to expire price for the NYMEX WTI Light Sweet Crude Oil Futures One month (i.e. floating rate is re-set once a month) Cash Six months (Jan 1 to 31 June)
Chart 1 : Fixed Floating WTI Crude Oil Swap
The floating rate for Jan 31 is fixed at the start of the swap. The floating rate for Feb 28 will be the settlement (spot) rate determined from the expiry of the Jan 2012 futures contracts. For Mar 31, the floating rate will be the settlement (spot) rate determined from the expiry of the Feb 2012 futures contracts. And so on. Chart 2 illustrates the swap payments in a time line. Chart 2: Timeline for the Fixing and Paying of the floating rates in the swap
Chart 3 shows a hypothetical example of the projected fixed and floating prices for the swap as at Jan 1. The projected cash flow is used to value the swap in the books of the parties. The floating rates are estimated from the referenced one-month futures prices.
Chart 3: Projected Fixed and Floating Rates for the Swap as at Jan 1
The Similarities between a swap and a future The Fixed Rate Payer could also choose to enter into futures contracts instead of a swap. For example, if he wanted to hedge some monthly oil positions from January to June, he could choose to enter into one-month futures contracts in January, February, March and up to June. At the end of each month, assuming the settlement is in cash, he would pay or receive the difference between the settlement (spot) price of the WTI crude oil and the price he paid for the respective one-month futures. Looking back at Chart 2, the settlement price of the futures contracts is already reflected as the floating rate of the swap. The fixed price of the swap, $80, is similar to the price paid for the future. Converting the swap into a future Following the above, we can convert the swap into a future. This is done by multiplying the total notional quantity of the swap (600,000 barrels) by its remaining duration (6 months or 181 days) and then dividing by the number of units that make up one futures contract (1,000 barrels = 1 futures contract). The number of futures equivalent contracts is then allocated pro rata to each month or fraction of a month (based upon the number of days remaining in each month) remaining on the swap. This working is shown in Chart 4.
Chart 4 – Converting the swap into futures
Now, instead of one swap comprising six monthly periods that settle at the end of each month, the swap holder now has equivalent futures contracts that expire on the 22nd of each month. If the conversion took place on Jan 1, the next payment date would be Feb 22, based on the settlement of the Feb futures contracts. Is the conversion like for like? One would question if the conversion results in exactly the same position for the swap parties, especially in cash flow projections and valuation. The following are some of the analysed differences: i) Different payment dates Payment dates in the swap and futures are notably different. In the swap, settlements are made at the end of each month. In the converted futures, settlements will be on the 22nd of each month. The first payment date under the swap was Jan 31. In the converted future, it is now Feb 22. The most likely reason for this is that an earlier feasible payment date of Jan 22 would be earlier than the payment date of Jan 31 under the swap, which may not be practical for some swap parties. ii) Different reference futures month In the swap, the settlement on Feb 31 is the difference between fixed ($80) and spot price on Jan 22. When converted into futures, the settlement on Feb 22 will be the difference between fixed price ($80) and spot price on Feb 22 itself. The time lag disappears when the conversion takes place. iii) Number of futures contracts will affect the cash flows.
The rounded number of futures contracts to approximate the swap notional results in an “economically equivalent future”. However, as observed in Chart 4, the term of the derivative is now lengthened to Aug 22. This will alter the cash flow profile and valuation of the swap that will be converted into futures. The hypothetical cash flows for valuation are illustrated in Chart 5 and Chart 6. We see that the same Feb, Mar, Apr and May futures prices used in both charts to represent the floating rates. However, the timing of the cash flows is not the same. We also see that the converted futures rely on further month future prices (June, July and August), which were not applicable in the swap. This results in varied cash flows that will give different valuations. Chart 5 – Projected cash flows from the swap
Chart 6 : Projected Cash Flows from Futures
Conclusion It will be interesting to follow the market reaction, if any, to the conversion of swaps into futures. Depending on the commodity price volatility at the time, some swap holders may experience considerable mark-to-market changes depending on the price of the far end futures at that time. Incidentally, ICE announced very recently that the conversion would now take place sooner, in October this year. On the other hand, the success of the above conversion will determine the beginning of more and more conversion of swaps and other OTC derivatives into exchange
traded products. Especially if market participants are willing to give up the flexibility they benefit from OTC derivatives, in return for getting rid of counterparty risk.