Cleared Derivatives are derivative contracts which are executed via phone or electronic execution network but CLEARED at a Central Counterparty (CCP). Cleared derivatives require initial margin to be posted to the Clearinghouse by both counterparties. Profits & Losses are exchanged daily.
Bilateral Derivatives are derivative contracts which are executed via phone or electronic execution network and held as a private contract by both counterparties. Bilateral Swaps require an independent amount to be posted as a good faith deposit. Profits & Losses are exchanged daily.
Other differences between Cleared & Bilateral contracts
1) Bilateral contracts are risk managed with each counterparty individually. Each counterparty is assigned a different derivatives limit (larger counterparties are able to trade in larger size and perhaps for longer tenors) and margin threshold.
2) Cleared contracts are risk managed by the CCP. the CCP becomes the counterparty to all contracts cleared. So all counerparties post the same amount of margin for a swap with the same terms and conditions.
3) The documentation also differs greatly.
Bilateral Contracts in addition to requiring the ISDA Master Agreement and Annex A, also require a Standard Initial Margin Method (SCSA) and nowadays the General Master Repurchase Agreement (GMRA). Collectively these documents binds the two counterparties together and spell out how they will conduct all business with each other.
Cleared Contracts in addition to requiring the documentation of the clearinghouse will also require a collateral document (i.e., third party Repo) to show the CCP the counterparty can post collateral.
The Risks of an Interest Rate Swap
EXAMPLE: 5 year swap (“we” the bank are paying fixed & receiving LIBOR)
The primary risks of a single currency swap are:
1) Counterparty Credit Risk (effected by the periodicity of payments of the swap)
2) Volatility Risk (effected by the tenor of the swap)
1) The Impact of Counterparty Credit Risk
1) In between payment dates, if we are paying the fixed rate and rates go down à we are making money
- We will receive collateral from the counterparty
2) In between payment dates, if we are paying the fixed rate and rates go up à we are losing money
- We will pay collateral to the counterparty
FIGURE 1 – Illustrates market risk exposure over the life of the swap
1.a) Impact of Periodicity of Payment
Our example illustrates a swap paying and receiving on the same periodicity has been used.
1. Assume we’re paying Fixed on a semi annual schedule & RECEIVING LIBOR on a quarterly basis
We are receiving the quarterly cash flow TWICE AS OFTEN as we are paying our semi-annual cash flow. Therefore we have (moderately) less risk
2. Take this to an extreme; We are paying Fixed once a year and Receiving LIBOR on a Monthly basis
We will receive 11 cash flows before we have to pay out our one year cash flow. Therefore we have 11 months to observe the payment record of the counterparty.
2) Impact of Counterparty Credit Risk As Time Passes
As time passes and the swap has performed well (cash flows are netted and paid) over time, the counterparty credit risk remains the same. But there’s less time to maturity. The volatility effects come into play and lowers the risk of the swap.
FIGURE 2 – Illustrates Credit Risk Exposure of a 5 Year Swap as time passes
3) Impact of Volatility
1) Impact of volatility rises as time to maturity increases.
2) As time passes the range of probable prices increases
Volatility, Market Risk & MPE
At inception of the 5 year swap,
1) Maximum Potential Exposure (MPE) comes in at approximately 2.5 years.
2) As time passes MPE decreases. With 2.5 years to maturity, MPE will come in at ~1.25 yrs.
The market risk of an interest rate swap is the combination of how often cash flow are paid and the difference in timing of those cash flows.
These variables will a direct effect on the Initial margin of a swap.
Volatility effects the market risk of a swap as time to maturity is greater.
The longer the tenor of the swap, the larger the initial margin