Implications of the BMR regulation – possible scenarios, hedging and interest rate swap valuation

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Implications of the BMR regulation - possible scenarios, hedging and interest rate swap valuation

Bartkowiak M. - PhD, Poznan University of Economics and Business, Poland

Dobosiewicz К. - student, Poznan University of Economics and Business, Poland

The main goal of the following study is to determine the possible hedging opportunities due to the BMR regulations ' implications by identification of theoretical long-term loan scenarios covering transition period and Interest Rate Swap valuation. Scenario recognition is based on the advanced report review of current Working Groups (i.e. ECB, ISDA, EMMI) and aims to widen the potential risks in long-term financing, which has not been yet considered in the public consultations. There have been four scenarios identified of which three can be hedged by the strategies with a use of IRS. The empirical results of the case of CHF market provide the indication that in the regime of stable interest rate perfect hedge requires specific conditions of the alternative rate change. Contrarily, in the raising interest rates regime the most profitable is a long position in IRS and the perfect hedge requires inconsistent with the regime assumption move of the alternative rate. hedging swap transition

The structural changes of the interbank money market and detected manipulations of benchmarks forced the European authorities to implement a reform to regulate the process of quoting and administration among the European Union countries. The EU Benchmark Regulation (Regulation (EU) 2016/1011, "BMR") introduced on 8/06/2016 came into force as of 1/01/2018 establishing two-year transition period for the current benchmarks, which due to their calculation methodology, would not be able to fulfil the reform requirements. Thus, it creates various types of challenges concerning legal adjustments, as well as the valuation of financial instruments and products that are based on particular discontinued rates. The benchmarks affected by the reform include Interbank Offered Rates underlying instruments of value over 370 trillion of dollars, hence the prevention from the drastic transition is the key to achieve the financial market stability. It has been already announced that LIBOR will not be quoted after 2021, so establishing alternative reference rates in the following years seems to be a priority. The uncertainty of the future decisions could especially affect debtors of the long-time credits based on the floating rates.

The paper provides an overview of the possible outcomes resulting from the BMR regulation to determine theoretical scenarios, which could be faced by the credit counterparty in a long-time financing during the transition period. Moreover, in case of defined scenarios, it is examined whether it is possible to reduce the risk by implementing hedging strategies using interest rate derivatives. The tested hypothesis is whether a negative impact of the benchmark reform in longterm loan could be decreased using such strategies in two assumed interest rates regimes.

The research methodology is threefold. The first step consists of the literature and authorities reports review, which aims to give the basis to define possible scenarios of the BMR reform results. It mainly focuses on the reports provided by the authorities such as International Swaps and Derivatives Association, European Central Bank, Bank for International Settlement, benchmark administrators and Working Groups paper releases. Secondly, the scenario analysis is conducted to determine whether the hedging strategies using derivatives can be implemented regarding different offered credit conditions. There are two approaches considered: evolutionary and revolutionary. Evolutionary approach assumes moderate transition (i.e. the transition to the alternative that is identified as relevant in terms of volatility), while revolutionary describes the situation of severe changes in the alternative reference rate. Thirdly, the defined strategies are empirically examined by the case study of CHF LIBOR and SAR (Swiss Average Rate, i.e. suggested alternative rate) transition. The hedging possibilities are tested in the stable interest rates regime and the rising interest rates regime.

The case of the Swiss franc market is an example of the successful implementation of the BMR reform as commonly used TOIS rate has already been replaced by SARON in 2017, thus it gives an indication of probable successful transition from LIBOR in the future. The empirical part of the study includes the valuation of the Interest Rate Swap contract. The source of data used in valuation is the Bloomberg platform as of October 2018. Hence, it is assumed that the current level of reference rates corresponds to this in the transition period.

Literature review

First analysis of the transition methodologies concerning credit products are described in the Market Participant Group (2014) report. The proposed methodologies and possible scenarios included two types: existing benchmark modification and current benchmark replacement. It was indicated that the second type change is concerned to increase legal risk, infrastructure scale and the time scale. Although, the MPG report considers multiple scenarios and methodologies, some of them are not relevant nowadays (e.g. the development of "IBOR+" concept).

As of the reform implementation in January 2018, the main financial institutions have started to create Working Groups which aim to provide solutions and recommendations regarding change in quotation of existing benchmarks, proposal of alternative rates and transition methodology. Those groups has been focusing on the particular benchmarks or families of benchmarks, for instance International Swaps and Derivatives Association (2018) currently consults the methodologies for GBP LIBOR, CHF LIBOR, JPY LIBOR, TIBOR, Euroyen TIBOR and BBSW for derivatives market; European Central Bank's Working Group (2018) started to develop new alternative benchmark (ESTER), which intends to be a replacement for EONIA; European Money Market Institute (2018) works on the Hybrid Methodology for Euribor that it could be BMR compliant. Most of the recent papers, however, do not provide the transition methodologies in terms of the long-term credit products. Finally, the possible outcomes of LIBOR discontinuation in such products are discussed by Gottrige & Hutto-Shultz (2017). Due to the uncertainty and work in progress about the solutions, the research provided by mentioned sources are a core of the theoretical scenario identification in this paper.

Methodology for hedging strategy and Interest Rate Swap calculation are provided by Hull (2018), Kellison (2009) and Bartkowiak & Echaust (2014). The IRS approach of calculation is FRA based with Overnight Interest Swap discounting (i.e. as suggested by Hull (2018), OIS curve provides risk-free rates for discounting).

Results

The study allows to indicate at least four different scenarios that the debtor of long-term loan could expect as the result of the benchmark discontinuation. First scenario assumes the transformation of the credit based on the floating rate to the fixed rate loan as the reference rate would correspond to the last quotation of the benchmark. Taking into account the fact that the alternative reference rate would be quoted, a debtor could take a short position in the IRS contract. Second scenario considers a direct transition from old benchmark to the alternative. To provide the hedge of risk, debtor can take a long position in IRS to pay a fixed rate instead of the floating alternative. Third scenario is a combination of two previous situations. The bank offers to the credit holder the possibilities to pay fixed rate based on last quotation of the benchmark or floating provided by the alternative rate. Depending on the conditions of the contract adjustments and the spread in the moment of transition, the debtor can hedge the risk of unfortunate decision by taking a right position in IRS contract. The evolutionary and revolutionary approaches are significant to distinguish the impact of the alternative rate volatility (it is assumed the evolution of SAR considers change of three standard deviation (-/+) of historical quotes to the mean historical value of the rate). The last scenario presents the situation that the credit holder, due to unsatisfactory contract conditions, high spread and volatility of a new benchmark, can use the Material Adverse Change clause to refuse to complete the contract. As the loan contract is discontinued, there is no need to implement any hedging strategy, although both counterparties suffer the potential losses. The situation can be indicated as the worst-case scenario, which could bring serious consequences to the financial system stability.

The IRS valuation assumes that at time T0 the contract is created. The IRS rate is calculated as rate that balances the payments from fixed and floating parts of the contract (as the value of IRS for both counterparties should equal zero). The notional value is 1 million CHF. At T1 (after one year), the value of IRS is calculated to check whether the position taken in the scenarios allows to hedge the risk.

Figure 1.

IRS valuation under stable interest rates regime vs. SAR3M quotation in T1 (Source: Own elaboration)

There are two regimes considered in the Interest Rate Swap valuation. First regime assumes the stability of interest rates, i.e. the OIS curve remains unchanged for the next period of valuation. The Fig. 1. shows the sensitivity analysis of the IRS value in respect to change of alternative rate - SAR. The highlighted area indicates the evolutionary approach of alternative rate change.

The breakeven point indicates perfect hedge corresponding to SAR3M equal -0.39%, what requires revolutionary approach. In this regime, short position in contract is more profitable, thus the first and third scenario (if this position was chosen by the party) could be advantaged. The following Table 1. describes the hedging opportunities for each scenario taking into account SAR3M values in Ti.

Table 1.

Hedging opportunities of theoretical scenarios in respect to SAR3M value in Ti - stable interest rates regime (Source: Own elaboration)

Figure 2.

IRS valuation under rising interest rates regime vs. SAR3M quotation in Ti (Source: Own elaboration)

The second considered regime assumes an increase in interest rates (both SAR and OIS). This regime is adequate to current market conditions; hence it should be more likely to appear in the transition period. Fig. 2. presents the IRS valuation corresponding to the change in SAR3M in different interest rate environment.

The breakeven point of -1.09% means that to achieve perfect hedge SAR3M value must drop over 31 b.p., what is in general inconsistent with assumed regime. More likely is to benefit from long position as it indicates evolutionary approach. Table 2. summarizes hedging opportunities depending on the theoretical scenarios and SAR3M values.

Table 2.

Hedging opportunities of theoretical scenarios in respect to SAR3M value in Ti - raising interest rates regime (Source: Own elaboration)

Conclusion

Identified scenarios allowed to propose two hedging strategies using IRS contracts to secure the transition period implied from the BMR regulations. Hedging of the negative impact of the BMR implications is possible under specific conditions. In case of Swiss franc market, to achieve hedging breakpoint SAR3M should increase (in stable interest rates regime) or decrease (in raising interest rates regime). Perfect hedge requires revolutionary path of the interest rates movements, but in terms of the second regime it is inconsistent with the main assumption, thus it is more likely to benefit from taking long position in IRS contract.

The transition process considered in this paper, however, gives a simplification. In reality, the uncertainty about the benchmarks' future and the execution of the reform appear to entail the greatest challenge of predicting which scenario is most likely to happen.

References

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