The Derivatives Thread

[sle]

If you wish... Interest rate swaps by the way are OTC Derivatives.

LOL, yes. What's your point?

For starters, reread what I wrote (reading comprehension is an important skill, even for a thinker ). Then, instead of copy-pasting some pseudo-educated crap you found on the internet, try to understand the difference between gross notional and netted MtM exposure.

 

[Stockolio]

If European Banks fail, it won't implode the world's financial system ? Is this what you are saying

 

[sle]

If European Banks fail, it won't implode the world's financial system ? Is this what you are saying

No, that's not what I am saying. I am saying exactly what I am saying, but let me go over it once more.

Netted risk exposure between counterparties,as opposed to adding up all of the notionals, is the right way of looking at this risk . Imagine that I pay you 2.5% in a 10 year USD interest rate swap, 1 billion of notional. A couple years passes and I receive 2.75% in a 7 year swap, 1.1 billion of notional. So by the gross notional metric it looks like we really increased the counterparty risk, since the gross notional gone up from 1 billion to 2.1 billion. In terms of netted risk exposure, however, we have actually reduced risk since the two of us are roughly flat in terms of 7-8 year IRS exposure to each other in dv01 terms.

Why is that? Because we exchange MtM margin based on some agreement at regular interval. So if one of us defaults next week, what you and I are exposed to is (a) unaccounted accrued amounts on the coupons and (b) mark to market in case the market moves. Thus, even though we had 1 billion and now have 2.1 billions in notional between the two of us, the losses in case of default would have been worse before we traded the second swap, even though it grew the gross notional.

PS. a cleaner example is a swap with identical dv01 traded back and forth across a relatively short period of time, but I wanted to illustrate how hard it is to gauge the net risk exposure.

 

[sle]

If European Banks fail, it won't implode the world's financial system ?

Regardless of the actual exposures, multiple failures of system-forming banks it definitely might. A scenario that comes to mind is when some stuff on their balance sheets goes bust - e.g. if some big borrower like Italy goes bust.

 

[Stockolio]

In terms of netted risk exposure, however, we have actually reduced risk since the two of us are roughly flat in terms of 7-8 year IRS exposure to each other in dv01 terms.

In theory what you are saying can technically be right, but in practice isn't. Compression doesn't decrease the risk in my view. Suppose A and B enter into a 10-year swap, but a year later A wants to close the position. If A and B cannot agree on termination terms, A might enter into an offsetting 9-year swap with C. As a result A now has two swap contracts and double the counterparty risk. Multilateral compression can knock out the contract between A and B, so if A owes B $10, and B owes C $10, then B can be eliminated and A will owe C the $10. Yes ill give you that.

https://www.reuters.com/article/derivatives-swaps-compression-hits-us1-q-idUSL8N1JO356

In theory it works fine, but if a Big domino is to fall, even with ECB QE and bail out, there will be serious consequences, regardless of net exposure of not, there all drinking the same water.

 

[sle]

In theory what you are saying can technically be right, but in practice isn't. Compression doesn't decrease the risk in my view. Suppose A and B enter into a 10-year swap, but a year later A wants to close the position. If A and B cannot agree on termination terms, A might enter into an offsetting 9-year swap with C.

We are not unwinding an existing position, we were adding. I was simply giving an example of an increase in notional that actually reduces the counterparty risk. The only statement I am making (for the 3rd time now) is that using the notional amount to gauge risk is wrong. We can get into the complexities of exposures, CSAs, novations and many other things but you have to pretend to actually want to learn about that stuff.

And again, reading comprehension. Did I mention compression anywhere?

 

[sle]

In theory it works fine, but if a Big domino is to fall, even with ECB QE and bail out, there will be serious consequences, regardless of net exposure of not, there all drinking the same water.

Okay, fine, I'll play. Let's imagine that we get a serious disaster, like a disorderly default of DB. My thinking is that it's not going to be the derivatives exposure that will take the house down, but rather the freeze in the short-term credit markets.

 

[Windlesham1]

DB is a dead bank walking anyway. OTC derivatives are based on presumptions, however their debtors are not in good shape. Selling German widgets to pauper nations is not a good business model. Anton Kriel has a ton of long dated puts down to €2 strike. The phoney DB merger may spoil that plan however

 

[newwurldmn]

Okay, fine, I'll play. Let's imagine that we get a serious disaster, like a disorderly default of DB. My thinking is that it's not going to be the derivatives exposure that will take the house down, but rather the freeze in the short-term credit markets.

You have spent a lot of words instead of just watching the “bonfire of ignorance.”