Interest Rates Derivatives Products An Overview Moscow Interbank Currency Exchange

transcript

Interest Rates Derivatives ProductsAn Overview

Moscow Interbank Currency Exchange21 November 2006

liquid capital__________________________________

• Liquid Capital Market’s - who we are and what we do

– Our markets

– Our specialities

• Options market making

– A view from the trading desk

– How do we provide liquidity

• Futures trading

– A word on pricing

– Basic strategies

• What makes a market?

– Product development as an integrated process

– A fine balancing act

• MOSIBOR / MOSPRIME: key considerations

– Futures contracts: what market structure?

– The virtuous circle: liquidity breeds liquidity – how do you build it and maintain it

Summary

liquid capital__________________________________

•Liquid Capital - who we are and what we do–Our markets –Our specialities

A short introduction

• Liquid Capital Markets leading Market Maker

and liquidity provider on the main European and

Asian equity and fixed income products

• Liquid Capital Securities offers an

independent global

execution brokerage service for futures and options to an institutional client base spanning more than

16 countries

Who we are

•We are the first port of call for brokers with institutional business

•We trade large volume

What do we think

•Profitable trading is

a function of:

What do we think

•Speed and accuracy

•Research, knowledge and

insight

What do we think

•We believe passionately

What do we think

•Building

relationships based on trust

Why are we different•We are able to absorb more trades in

larger volume therefore we can make

narrow spreads

even in difficult market conditions

Why are we different

•We control volume and therefore keep our

prices competitive

•We are able to be the

first to act to the

changes in

•We commit to

stand by our prices

•We understand the interplay between

technology and our

markets and

products

Our specialities – Liquid Capital Markets

•Options

•Pure market making

•Volatility

•Risk management

Our MarketsLondon

• Single stock options– All component stocks of Dax

30– Nokia AG

• Interest rate options

– Eurex Euro-BUND– Eurex Euro-BOBL– Eurex Euro-Schatz– Euronext LIFFE Euribor– Euronext LIFFE Short Sterling

• Equity Index options

– FTSE 100– DAX 30– EuroStoxx 50– AEX

Sydney• Asian Index Product

– KOSPI options– KOSPI futures– NIKKEI options– NIKKEI futures (NK225)– JGB (Japanese Government Bond)– XJO (options on ASX 200)– AP (futures on Australian Share Price

Index – SFE)

• Australian Single Stocks– National Australia Bank (NAB)– Telstra Corp (TLS)– BHP Billiton Ltd (BHP)– Rio Tinto (RIO)– Woodside Petroleum (WPL)– Woolworths (WOW)– Commonwealth Bank (CBA)– News Corporation (NWS/NWSLV)

Our specialities – Liquid Capital Securities

•Best execution

•Price discovery

•Specific

product expertise

•Coverage of futures and options

worldwide and across asset classes

•Access to quotes from Liquid Capital Markets

•Analysis and

research

•Options market making

–A view from the trading desk

–How do we provide liquidity

Summary

A view from the trading desk – A day in the life…

• 6:30 am: trading team gets in

• 6:35 am: catch-up with news and review of book marks and quote sheets

• 6:55 am: coffee and gents break

• 6:59 am: last checks

•7:00 am: hell breaks loose!

•6:00 pm: market closes -

world returns to its

normal state

Who is the Market Maker?

•He is not a car dealer

•He is looking for fair market equilibrium

Who is the Market Maker?

•With his pricing he ads transparency to the market

•For a market maker it’s all about

demand and supply

The bottom line•Trading options is a very demanding job. You are supposed to:

•Deal with the unknown

•Make split-second decision

The bottom line

•Keep tight spreads

•Keep the market happy

•Keep your sales staff happy

The bottom line• Keep your risk manager happy

• Keep your boss happy

•Keep the money coming in

How we do it

•Continuous two-way prices

•Strict delta, vega and theta

limits

•Each position is

dynamically hedged

How we do it•Initial hedge via futures then we

lock in the value of the option via a

combination of spreads

• The natural order flow is sufficient to

absorb most of the hedge activity

How we do it

•Tightness of spreads

heavily dependant on size

•We watch out for

directional players

How we do it

• We pay attention to

“distressed options” i.e. options that have moved

uncharacteristically away from fair value

How we do it

•We watch out for spreads that can turn

very quickly close to

maturity if near to at-the-money strike prices

Interest Rates Options

General hedging categoriesType of exposure Strategy

Short-term debt issuer Buys puts on short-term IR future

Short-term investor Buys calls on short-term IR future

Medium-term debt issuer Buy series of puts on short-term IR future

Medium-term debt investor Buys series of calls on short-term IR future

Long-term debt issuer Buys puts on long-term IR (Bonds)

Long-term debt investor Buys call on long term IR (Bonds)

A typical trade• Market participants with different aims

•Speculator forecasts a rate hike

• He enters a probability-based trade on an expectation

A typical trade

•Hedger: wants to hedge exposure against rate hike

• He wants to eliminate the

risk of an

expectation

A typical trade

•What do they do:

•Speculator - buys ladder

•Hedger - buys call spread

A typical trade – In practice

• Euribor cash rate: 3.50 %

• Euribor March 07 Future: 96.09 (implied rate 3.91)

• Indicative option prices AskBid

– March 07 Euribor 96.000 call 0.11 0.12– March 07 Euribor 96.250 call 0.015 0.020– March 07 Euribor 96.500 call 0.050 0.070– March 07 Euribor 96.750 call 0.000 0.001

A typical trade – In practice•Speculator buys ladder:

–Buys 1 March 07 Euribor 96.250 call

–Sells 1 March 07 Euribor 96.500 call

95.5 95.75 96 96.25 96.5 96.75 97 97.25 97.5

•Hedger sell call spreads

95.5 95.75 96 96.25 96.5 96.75 97 97.25

•LCM:

95.5 95.75 96 96.25 96.5 96.75 97 97.25 97.5

Considerations

•No pull to par but drift

•Mean reversion of

volatility and rates

Considerations

•Price options off an

underlying future or fwd instrument

•Use implied volatility

•Futures trading

–A word on pricing

–Basic strategies

Summary

Pricing an Interest Rate Future (1)

The price quotation of a 3 month interest rate future is 100 minus the (expected) future 3 month interest rate, and the interest rate is quoted on a per annum basis

3m rate = 3.57%Dec future

=100 - 3.57 = 96.43

3rd Wed

of DecToday

3rd Wed

of Dec

3m rate = 3.57%

Dec future = 100 - 3.57 = 96.43

This demonstrates convergence

Pricing an Interest Rate Future (2)

As time passes the Jun contract price will fluctuate according to changing expectations

These can be calculated from EURIBOR rates0 3

m6m 9m

=3.6% 6m =3.7%9m =3.8%

91 days

90 days

92 days

Calculation of Forward Rates in the Money Market (1)

(1+0.036 x 91/360) (1+3f6 x 90/360) = (1+0.037 x 181/360)

3f6 = 3.767%

1+ 0.037 x 181/3601+ 0.036 x

91/360

3f6 = -1

0 3m 6m 9m 3m =3.6%

6m =3.7%

9m =3.8%

3f6=3.77%

91 days 90 days 92 days

6f9 3.9237%

(1+0.037 x181/360) (1+6f9 x 92/360) = (1+0.038 x 273/360)

1+ 0.038 x 273/3601+ 0.037 x

181/360

6f9 = -1

6m 9m 3m

=3.6% 6m =3.7%9m =3.8%

6f9=3.92%

91 days

90 days

92 days

3f6=3.77%

Matching delivery date

Matching period

Co. needs to borrow €20,000,000 for three months starting in the future on the delivery

date of the Dec 3m € interest rate future (15/06)

Hedging with Interest Rate Futures (1)

No. of futures = €20,000,000 = 20€1,000,000

15/09 15/033m borrowing

Matching delivery date

Non-matching period

Co. needs to borrow €20,000,000 for six months starting in the future on the

delivery date of the Dec 3m € interest rate future (15/12)

Period being hedged

Period covered by future

No. of futures = €20,000,000 x 6m = 40 €1,000,000 3m

15/12 15/03 15/066m borrowing

The previous slide showed that we needed to sell 40 contracts.

The question now is which contracts should we sell?

There are two possibilities

1. Sell 40 Dec futures

2. Sell 20 Dec and 20 Mar futures

Stack Hedge

Strip Hedge

Calculating the Strip Rate

360period 6mth inDay

r1 strip

If a strip hedge is utilised, the expectedrate (the strip rate) achieved can

be calculated as follows

360MarPeriodsinDay

360DecPeriodsinDay

Mar Dec r 1r 1

Non-matching delivery date Matching period

Co needs to borrow €20,000,000 for three months starting in the future on 15/01. The delivery date of the Dec 3m £ interest rate

future is 15/12

No. of futures = €20,000,000 x 3m = 20 €1,000,000

15/1215/01 15/033m borrowing

Let’s say we choose to sell 20 Mar contracts

The basic hedge must now be adjusted to reflect the mismatch in

dates.

As a borrower, using a later dated contract

will expose the hedger to a flattening yield curve, whilst using an earlier dated

contract will expose the hedger to a steepening yield curve

Yield Curve Exposure - Steepening

Longer-dated rates rise more

Shorter-dated rates rise less

Steepening yield curve

The forward rates will rise relative to near rates,i.e. the further futures contract will fall MORE

Yield Curve Exposure - Flattening

Longer-dated rates fall more

Shorter-dated rates fall less

Flattening yield curve

The forward rates will fall relative to near rates,i.e. the further futures contract will rise MORE

To protect against yield curve risk we should execute an appropriate number offutures intra-market spread trades

Long spread - buy nearer dated, sell later dated - will be profitable if the yield curve

steepens

Short spread - sell nearer dated, buy later dated - will be profitable if the yield curve

flattens

A hedger protecting against an increase in interest rates will have sold futures as the

basic hedge.If, because of mismatching dates, they are using later dated contracts, they need to

additionally execute an appropriate number of short spreads.

No. of spreads

Time between start of exposure period and future’s

delivery dateFuture’s contract length

Basic number

15/1215/01 15/03

3m borrowing

2 monthsNo. of spreads = 20 x = 13.33 23

Summary Dec Mar

Basic -20

Spreads -13.33 +13.33

Total -13.33 -6.67

Sell 2.67 Dec/Mar spreads

Rounded to -13 -7

i.e. still short 20 contracts net total

Alternatively: sell 20 Mar futures and additionally

Sell 13.33 Mar/Jun spreads

Summary Mar J un

Basic -20

Spreads -13.33 +13.33

Total -33.33 +13.33

Rounded to -33

+13i.e. still short 20 contracts net

Another alternative would be to do the basic hedge by selling 20 Dec futures

As this is using earlier dated contracts, the short hedger will now have to do a

number of long spread trades

No. of spreads = 20 x = 6.66 13

15/01 15/03

3m borrowing1 month

Summary Dec Mar

Basic -20

Spreads +6.67 -6.67

Total -13.33 -6.67

Rounded to -13 -

7Note that after the basic hedge has been adjusted with spreads to cover the yield curve risk, the answer comes to the same whether we start with Dec or Mar contracts as the basic hedge

Calculating the Strip Rate for Non-Matching Periods (1)

A company needs to hedge for a 6-month period starting on 20 Jan. What is the

anticipated strip rate if the following futures prices apply?

Dec (15/12) 94.45 Mar (20/03) 94.62 Jun (19/06) 94.14

Calculating the Strip Rate for Non-Matching Periods (2)

+ +( ) x 360/1815.55% x 59/360

5.86% x 31/360

5.38% x 91/360

= 5.5176%

Futures prices: Dec 94.45 Mar 94.62 Jun 94.14

•What makes a

market?–Product development as an integrated process

–A fine balancing act

Summary

• A liquid underlying

•Diversity of players

•Easy access to liquidity

What makes a market

•Technology –

sophisticated trading platform

• Product range

•Margining – efficient usage of collateral

What makes a market

•Simple contract design

•Reasonable

exchange fees

•Transparency

What makes a market

•A well capitalized clearing house

•The upshot: no need for credit lines

What makes a market

• Exchange traded product development is

about meeting users needs

and filling gaps in the offering

• It takes deep

understanding of your

client base

• It implies hard choices

Product development

• It requires focus

• It takes time

•Exchanges cannot do it alone

anymore

Product development

•Market participants

cannot do it alone

• It takes a partnership

• It’s a crowded market you are

fighting for attention

Product development

• It is a phased approach

• The priority is in creating a healthy

underlying market

• The success is a mix of

ingredients

Product development

•Incentives

•Visibility

•Relevance

Product development

• Ask the question:

Who needs it

Product development

• Above all choose the path of least resistance!

Product development

Product development +

Market Structure +

Marketing =

Successful Product

A delicate balancing act

• Market structure is key

•Order driven book

•Designated Market Makers and

Liquidity Providers with

contractual obligations

A delicate balancing act

•Best form of marketing?

Education!

Product development - Marketing

• Identify who has more to

gain from using these products

and in return can provide support

• Be pervasive

Marketing

• Create a community of users

•Educate, educate,

educate

Marketing

• Enrol people who will

champion your product

• Be open minded

•One on one

Marketing

•Seminars

•Sponsored articles

•More seminars

Marketing

• Be committed•

Be passionate• Be

uncompromising•

Make it relevant

Marketing - Communication

•MOSIBOR / MOSPRIME–Underlying market

–Futures contracts: what market structure

–The virtuous circle: liquidity breeds liquidity

Summary

• Underlying market still relatively

•Promote the underlying

market actively

• Market it to issuers – supra and

corporate

• Improve overall visibility

MOSIBOR/MOSPRIME - Key considerations

•Clarify legal status of Exchange

Traded Derivatives contracts is Russia

•Order-driven based on

pro-rata algorithm, with priority given to the

first order at best price

MOSIBOR/MOSPRIME – Market Structure

• Introduce a Designated Market

Maker (DMM) scheme with incentives

• Introduce wholesale facilities

MOSIBOR/MOSPRIME – Market Structure

• Work with brokers and parties that provide flow

• Make data freely available

• Continue to improve the technology – STIRS are

sophisticated products!

MOSIBOR/MOSPRIME - Key considerations

The benefits of central markets

•Natural venue where

counterparts can be found

• Price discovery

•Transparency

•Liquidity reduces spreads and execution cost

The benefits of central markets• Market depth reduces execution

• Liquidity is “sticky” - easy to access, difficult to move

• Exchanges invest in developing liquidity

Liquidity breeds liquidity

•The virtuous circle

Prop.Traders

Market Makers

Brokers

Retail

Liquidity Pool

• Individual Liquidity Provider (ILP)

• Euribor Futures Contract STIR Liquidity Provider (SLP)

• Short Sterling Futures Contract (SLP)

• Eurodollar Futures Contract (SLP)

• New Market Participant – (NMP)

• Individual Liquidity Provider (ILP)

•Lower exchange fees for individual

proprietary traders

• Focus on developing liquidity on the back months

•Proven consistency in supporting order flow

in long-dated contracts

• Euribor Futures Contract STIR Liquidity Provider (SLP)

•Volume based discounts for

proprietary traders – firms and individuals

•Proven consistency in facilitating

price-discovery and injecting liquidity

• Market makers love incentives

• Incentives reward them for

adding value and putting capital

at risk

• They have to work hard for them

Liquidity breeds liquidity• Requires the right balance of

incentives and fair market structure

• In Euribor the exchange offers liquidity

provision schemes aimed at different market participants

• The result is a vibrant and tight market

Disclaimer

The material and information set out in this presentation is not intended to be an offer to buy or sell any derivatives. Any expression of opinion is based on sources believed to be reasonably reliable but is not guaranteed as to accuracy or completeness.

The material and information herein is general and for informational purposes only. The derivative market comprises volatility and considerable risks. To the maximum extent permitted by law no responsibility or liability can be accepted by Liquid Capital Securities Limited, any company or employee within its group for any action taken as a result of the information contained in this presentation. You are requested to seek specific advice when dealing with specific circumstances.

Liquid Capital Securities is regulated by the UK Financial Services Authority.

Interest Rates Derivatives Products An Overview Moscow Interbank Currency Exchange

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