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Deep Throat

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 well-known.

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 own them.

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 ABS spreads.

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 trade.

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 buy Treasuries.

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.