Interest Rate Swap markets are jargon-heavy. Traders live and breathe the language. Professional investors pick-up the nuances over time and the vicious circle of incomprehensibility is complete. However, now that Swaps markets have transitioned to electronic trading, will we see market-standard terms adopted across asset-classes?
Any interest rate swap will make or lose money as Rates go up or down. But what if an investor does not have an opinion on whether rates will go up or down? Perhaps, they think that short-term rates will go down and long-term interest rates will go up. In this case, they can employ a curve trading strategy. Our investor believes that 10 year rates will move differently to 5 year rates — in which case, they would be well served to enter a curve trade. If they think 10 year rates will go up or go up faster they should pay the fixed rate on a 10 year swap; and if they think 5 year rates will go down or go up slower they should receive on a 5 year swap.
This strategy highlights a very important feature of curve trading. These trading strategies are not held to maturity. In the case of a 5 year versus 10 year position, if our investor held such a position for 5 years, they would see their 5 year swap expire and be left with one outstanding swap — i.
It would therefore cease to be a curve trade! As a swaps curve is typically upward sloping i. If we were paying fixed on a 10 year swap, then we would also make money if swap rates moved higher, even if the spread between 5 year and 10 year swaps remained constant. This is typically achieved by agreeing a market coupon for the longest swap and subtracting the spread at which the trade has been agreed. We always talk in terms of the longest swap in the spread. Therefore, if the investor is buying selling , paying receiving , lifting hitting , taking giving or putting on a steepener flattener they are paying fixed on the longest swap.
And doing the opposite on the shortest leg. In swaps trading, the shortest and longest maturity legs are traded in equivalent directions; the risk of the intermediate maturity leg is equal and opposite to the sum of the other two legs. Another investor has a different view on the curve.
They believe that short-term rates will head higher, medium term rates will move lower whilst long-end rates will increase. Our previous investor had a view on the slope or steepness of the curve; this new investor has an opinion on the shape or curvature of swap rates. A butterfly or barbel therefore involves the simultaneous trading of three maturities on the swap curve.
A butterfly trade has three legs. Note that there is a double weighting for the intermediate swap rate. This is because another way to express the price of the butterfly trade is as the difference between the two spreads:. We typically agree upon the size of the belly in notional terms. We use the ratio of the DV01s to then calculate the notionals of the wings. The wings are the same way round e. Just as for spread trades, this is a delta-neutral curve trade, therefore the sum of the DV01s is always zero.
We again try to derive current market rates such that each swap has an NPV of zero and to avoid convexity from off-market coupons. Market participants will typically agree the swap rate on the intermediate leg, plus a value for one of the tenor spreads, to imply the coupon on one of the wings.
The coupon on the remaining wing is then calculated from the agreed price on the butterfly:. Therefore, if the investor is buying selling , paying receiving , lifting hitting , or taking giving a butterfly, then they are paying receiving fixed on the belly leg. And doing the opposite on the wings. Recently, we have seen the democratization of data in our markets. We have a level playing field of execution.
Craziness I tell you! We received this useful feedback from Igor Hlivka. Stay informed with our FREE newsletter, subscribe here. Direction We always talk in terms of the longest swap in the spread. This is because another way to express the price of the butterfly trade is as the difference between the two spreads: The coupon on the remaining wing is then calculated from the agreed price on the butterfly: The Future Recently, we have seen the democratization of data in our markets.
This particularly applies to butterfly trades where 1: Print LinkedIn Twitter Google. A Year In Review. Why a Margin Forecast is important.More...