Computational Finance Seminar
Large government sponsored enterprises, the Federal Home Loan Banks in particular, can obtain attractive floating rate funding by issuing complex callable structured notes and overlaying mirror cancelable swaps. There are thousands of such notes amounting to hundreds of billions of dollars outstanding. The structured note market is currently flourishing. Investors initiate the process by indicating the acceptable yield level, hence the term "reverse inquiry." The higher volatilities in the interest rate derivatives market relative to the bond market allow borrowers to synthetically sell the embedded call option in the note at an arbitrage profit. The success of a structured transaction hinges on the existence of a suitable cancelable swap. We will provide a brief tutorial on swaps and swaptions, along with a history of the swap market, and explain the mechanics of cancelable swaps. The proper valuation of the cancellation option is critical to determining the floating rate ("spread to LIBOR"). While market volatilities are readily available for European (one-time) cancellation options, these are not directly applicable to reverse inquiry deals, in which the options are normally exercisable more than once. Estimating the values of non-European options from European volatilities is technically challenging and computationally intensive. We will briefly discuss some methodological and computational approaches to valuation.
* Andrew J. Kalotay is President of Andrew Kalotay Associates, and is a leading authority on the management of corporate and municipal bonds. He has published extensively on a variety of bond-related topics, including valuation and debt management. His innovations include the concept of refunding efficiency (a widely used tool for managing callable debt) and the Ratchet Bond (a surrogate for conventional callable bonds that eliminates the transaction costs associated with refunding). Previously, Dr. Kalotay was with Salomon Brothers in the Bond Portfolio Analysis Group. Prior to that he worked at the AT&T Treasury and at Bell Laboratories. Dr. Kalotay holds a B.Sc. and M.Sc. from Queen's University and a Ph.D. from the University of Toronto. He is member of the Fixed Income Analyst Society's "Hall of Fame."