Saving $$$ on Swaps and Options Trades
A veteran-and anonymous-swap dealer reveals a simple trading technique that can help end-users cut costs.
Here's a trading technique that can save you tens or hundreds of thousands of dollars by improving your derivatives execution. I have seen this technique
work time and again in my seven years as a swap dealer, but it's still not
While many bond investors or treasurers think of swaps mechanically as
an exchange of fixed-for-floating payments, swap traders think about things
entirely differently. To them, swaps are about either buying or selling
swap spreads. Their trading book is not an interest rate book-it's a spread
book. In the jargon of swap traders, spreads are an asset-like stocks-that
increase in value when swap spreads widen.
This is a bit confusing to fixed-income practitioners, for whom spreads-such as credit spreads-are not something they want to increase (widen) when they
When an end-user asks a swap trader to receive fixed and pay floating
on a swap, the trader thinks "I'm selling spreads." To see this,
consider what happens to a swap trader's position if swap spreads rise immediately
after closing a swap. Higher rates reduce the value of the swap trade in
the same way that rising rates reduce the price of a bond. Selling a swap
spread is akin to shorting a stock-and you don't want to be short when the
price rises. In order to reduce a swap to just a short spread position,
the swap trader must sell Treasuries to hedge out the fixed-rate component
of the swap.
One sure way to save on your next swap is to limit your swap to trading
only spreads. After all, this is what swap traders trade.
Consider the following example of an asset-backed investor who wants
to create an attractive uncapped floating rate note by buying a five-year
fixed rate credit card asset-backed security and swapping it. With spreads
on credit card floaters historically tight these days, this trade can produce
a several-basis-point pick-up when swap spreads are tight relative to fixed
When our investor buys the bonds, the ABS trader must unwind a short
five-year Treasury position that was hedging the long ABS. To start saving
money, our investor should sell five-year Treasuries to the ABS trader.
Similarly, when paying fixed on a swap, our investor should buy five-year
Treasuries from his swap dealer because the trade requires the swap trader
to sell Treasuries.
In practice, these trades-called "trading notes"-will absolutely save you money. By working with both the ABS and swap traders on a spread
basis and agreeing with each of them to trade the Treasuries at a mid-market
price (which almost all traders will do if you press them), you can save
yourself, at a minimum, one-half of bid-offer on the Treasuries. From my
experience, however, the savings are often greater. When swap traders or
bond traders know that they are trading notes, their price (that is, the
swap or credit spread) will improve. On the swap this can easily be one-half
a basis point and on a five-year ABS even more. A $50 million, five-year
trade has an 01 equal to $450 per million. Thus one basis point savings
is worth $22,500.
There is another way trading notes can sometimes help. In most swap dealing houses, the swap trader must trade Treasuries and repo "in house"-that
is, buy or sell Treasuries with the internal Treasury trading desk and borrow
or lend Treasury securities with their Treasury Financing Desk. Although
this restraint of free trade is promoted internally by a firm's senior management
as "keeping profitability within their own firm," the reality
for a swapper is that this can be debilitating. If your swap dealer has
a lousy Treasury desk, trading notes can save you even more since the swap
trader won't adjust his swap spread to account for a bad internal Treasury
Trading options? The same logic applies. The trick is to limit your option trade to what option traders trade: volatility. Good mortgage investors
know this. Consider a mortgage investor looking to buy back some of the
optionality he is short by owning a mortgage pass-through. Suppose the investor
has determined that he needs to buy a one-year option giving him the right
to receive fixed on a 10-year swap. To hedge a sold receiver swaption, a
position that would lose money if rates declined, an option trader must
To trade notes with the options trader, you could figure out the amount
of 10-year Treasuries that has an equivalent duration to the option. This
only helps a little, however, because the option trader will do a more refined
analysis. His risk profile of the swaption will show exposures along the
curve. The more appropriate trade would be to trade a combination of two-year,
five-year and 10-year Treasuries.
In each case above, taking the interest rate duration out of the trade
by trading notes with your derivative dealer can lead to better trade execution
and save you money. Next time you have a good-size trade to execute, get
two prices, one with trading notes and one without. If they are the same,
ask your trader why.