Since its development in 2006, the RMB interest rate swap market has an average monthly transaction size of more than 2.6 trillion yuan. As an interest rate derivative, RMB interest rate swap has many functions, which can be used as a lightweight investment tool in the direction of Bo interest rate, as well as arbitrage and hedging. Based on the perspective of interest rate risk management, this paper introduces the basic concepts, market conditions, valuation and pricing of RMB interest rate swaps, introduces the effects and key points of RMB interest rate swaps in interest rate risk management through actual cases, and finally puts forward suggestions for commercial banks to use interest rate swaps and other tools to carry out interest rate risk hedging and hedging.
Introduction to RMB interest rate swaps
According to the Notice of the People's Bank of China on Relevant Matters Concerning the Launching of RMB Interest Rate Swap Business (Yin Fa [2008] No. 18), RMB Interest Rate Swap (IRS) refers to a financial contract in which the parties to a transaction agree to calculate interest and exchange interest based on the agreed RMB principal and interest rate within a certain period of time in the future. The exchange of fixed interest rate and floating interest rate is currently the most mainstream interest rate swap method. Generally speaking, the principal currency of interest rate swap is the same as the notional principal currency, in which the notional principal is not really delivered, but only used as the basis for calculating interest, and the interest payable and receivable are calculated through the notional principal during the interest payment period, and the difference is settled. In this sense, interest rate swaps are pure zero-sum games, and only the losses of opponents can form their own gains, but the theoretical basis for the birth of interest rate swaps is based on the "comparative advantage theory" that can achieve a win-win situation. For example, AAA companies have good qualifications and can be financed at a fixed interest rate cost of 5% or LPR+0.8% in the market, while BB companies are slightly less qualified and can only be financed at a fixed interest rate cost of 5.5% or LPR+1%. AAA wants to be financed by floating interest rate and BB is financed by fixed rate, and without interest rate swaps, AAA's financing cost is LPR+0.8% and BB's financing cost is 5.5%. If the comparative advantage is combined with interest rate swaps, AAA will be financed at a fixed interest rate of 5% and exchanged with BB to obtain a floating interest rate of LPR+0.6%, while BB will be financed at an interest rate of LPR+1% and exchanged with Company A to obtain a fixed interest rate of 5.4%, so that all parties can achieve a win-win situation.
In fact, an interest rate swap can be seen as a combination of a fixed-rate bond and an inverse floating-rate bond. For example, a long IRS position with a "floating and fixed" interest rate can be split into a long floating-rate bond with the nominal principal of the IRS and a floating interest rate at the reference rate, and a short fixed-rate bond with the nominal principal of the IRS and a fixed interest rate as the coupon rate (see Figure 1).
Figure 1 Schematic diagram of interest rate swap split
From the perspective of interest rate risk, since floating-rate bonds themselves have the characteristics of "going with the market", changes in market interest rates have little impact on the value of floating-rate bonds, so the main interest rate risk of the IRS comes from fixed-rate bonds split at the same price (see Figure 2).
Figure 2 IRS interest rate risk analysis
There are many sub-strategies for interest rate swap investment, including directional trading, interest rate spread trading, bond arbitrage trading, curve carry trading, butterfly trading, basis trading, etc. Its main role can be summed up in three points: First, speculation. Interest rate swaps do not need to deliver the principal, but use interest netting for settlement, which naturally comes with greater leverage, and the use of interest rate swap leverage characteristics to bet on the direction of interest rates can obtain greater returns without occupying funds. The second is arbitrage. The RMB IRS reference rate is mainly based on the repurchase and call rates such as FR007 and Shibor3M, and the long-term cost of funds can be arbitraged on the asset side by participating in the IRS, which is less risky than rolling lending. The third is hedging/hedging. Holding bonds with appropriate interest rate swaps can effectively hedge against the risk of bond valuation fluctuations.
Overview of China's interest rate swap market
China's interest rate swap market originated in 2006 and emerged in 2014, similar to other financial derivatives, with the characteristics of "originating from hedging and flourishing from arbitrage". In October 2005, China Development Bank and China Everbright Bank entered into an interest rate swap agreement with a notional principal of RMB 1 billion, a tenor of 10 years, and a floating end with a reference to a one-year fixed deposit rate. This business was announced after the issuance of the Notice of the People's Bank of China on Matters Concerning the Pilot Program of RMB Interest Rate Swap Transactions issued by the People's Bank of China the following year, and was the first RMB interest rate swap business in China. Since 2006, interest rate swap products have been gradually enriched and the number of participants has gradually expanded (see Table 1).
Table 1 Summary of important events of RMB interest rate swaps
Source: The author is based on publicly available information
According to the Foreign Exchange Trade Center, as of September 11, 2023, there are 768 RMB interest rate swap filing institutions, including policy banks, large state-owned banks, national joint-stock banks, urban commercial banks, rural commercial banks, foreign-funded banks, overseas banks, securities companies, insurance companies, insurance asset management, finance companies, financial leasing companies and various unincorporated asset management products. In terms of varieties, the main reference interest rate varieties of the interest rate swap business in mainland China are FR007, Shibor3M, LPR5Y, LPR1Y, CDB10, D10/G10, GB10, etc., and each reference rate is divided into specific interest rate swap varieties according to the term, such as 1-year FR007 interest rate swap, 5-year Shibor3M interest rate swap, etc. In terms of trading volume, the trading volume of RMB interest rate swaps in 2022 was 20.97 trillion yuan (nominal principal), of which interest rate swaps with reference FR007 and Shibor3M were the most active, accounting for 89.4% and 9.7% of the total trading volume, respectively. In terms of specific varieties, the 1-year FR007 swap and the 5-year FR007 swap were the most active, accounting for 37% and 22% of the total trading volume of the year, respectively. From January to August 2023, the volume of RMB interest rate swap transactions further increased to 21.15 trillion yuan, a year-on-year increase of 68% (see Table 2).
Table 2 Statistics of RMB interest rate swap turnover (trillion yuan)
Data source: China Money Network
Pricing and valuation of the IRS
The fixed interest rate is determined by making the discounted value of all future fixed and floating cash flows equal during the interest rate swap period, and the theoretical pricing is obtained. During this period, the valuation method is similar to the pricing method, discounting all fixed and floating cash flows to the current point in time and netting the difference to obtain the current valuation of the IRS. Take a 5-year interest rate swap linked to FR007 as an example, and the elements involved are detailed in Table 3.
Table 3 Elements of a 5-year IRS linked to FR007
Source: Bank of Jiangsu
The main steps of IRS pricing and valuation are: first, select an appropriate valuation curve to construct a standard term discount factor. According to the China Foreign Exchange Trade System Interest Rate Swap Valuation Manual, the IRS curves currently compiled and published include IRS fixing/closing curves, IRS market curves and IRS curves (not released to the public). Secondly, the linear interpolation method is used to obtain the discount factor of any non-standard maturity. In terms of interpolation, the curve can be directly interpolated, and the discount factor of the standard period can also be interpolated (see Table 4). Thirdly, the discount factor is used to extrapolate the forward interest rate for each interest-bearing period. Finally, the floating cash flow of all interest-bearing periods (1) is obtained by "nominal principal × the length of a certain interest-bearing period ×corresponding to the forward interest rate", and the fixed-end cash flow (2) of all interest-bearing periods is calculated at the same time, and the net cash flow is obtained through (1) and (2) netting, and the valuation at the time of valuation is obtained by discounting by using the discounting factor that is interpolated (see Table 5).
Table 4 Standard maturity discount factor
Source: Bank of Jiangsu
Table 5 Non-standard maturity discount factor and the first cash flow of the IRS
Source: Bank of Jiangsu
Through calculations, it is known that the theoretical fixed interest rate of the IRS on July 15, 2019 should be 2.7138%, and if 2.9125% of the average fixing price of the day is used as the fixed interest rate, it will incur a valuation loss of about 0.93% on the trading day. There is a certain difference between the market price and the theoretical price.
Risk management applications for the IRS
As a financial derivative product, IRS has its own risk management attributes at the beginning of its birth and is a good interest rate risk management tool. For banks, the liability side can switch the cost of liabilities through interest rate swaps, such as locking in the cost of borrowing funds through interest rate swaps during the expected interest rate rise, and the asset side can hedge the valuation risk of fixed income assets, such as hedging the interest rate risk of inactive bonds through interest rate swaps during the expected interest rate rise. In addition to the substantial benefits of risk management, the "underlying assets + IRS" portfolio can also be used in conjunction with hedge accounting to smooth financial statements and avoid large fluctuations in current profits/equity. According to the Accounting Standard for Business Enterprises No. 24 - Hedge Accounting (Cai Hui [2017] No. 9), hedge accounting refers to the method of including the gains/losses arising from hedging instruments and hedged items into profit or loss (or other comprehensive income) in the same accounting period. Taking the "Bond + IRS classified as OCI" portfolio as an example, the entries that use hedge accounting and do not use hedge accounting in the face of valuation changes are shown in Figure 3.
Figure 3 Comparison of entries before and after the use of hedge accounting for the "OCI Debt + IRS" combination
Empirically, the use of the IRS to hedge the underlying bond assets can achieve a good hedging effect. Take 190208. IB(1) For example, if an institution buys 1 million shares of the bond at a price of $100.09 in the secondary market on July 15, 2019, and intends to hedge the risk with a 5-year IRS(2) linked to FR007. According to the valuation of China Bond, the DV01 of the bond on the day is 0.044959, and then according to the calculation formula of interest rate swap DV01 given by the Foreign Exchange Trade Center:
It can be calculated that the DV01 corresponding to every 100 yuan of notional principal of the IRS on the trading day is 0.040638. According to the DV01 matching principle, 110.63 million yuan of IRS long contracts should be participated. From the perspective of the trend of interest rates after portfolio construction, the yield of the 5-year CDB bond has a very high correlation with the average price of the 5-year FR007 swap (see Figure 4), and from the perspective of hedging effect, the valuation of single bonds unhedged by the IRS has fluctuated by 6.03% since July 2019, and the valuation fluctuation of the portfolio hedged by the IRS has been 2.51%, and the IRS has achieved its expected purpose (see Figure 5).
Figure 4 Trend of the average swap price of the 5-year CDB yield and the 5-year FR007
Source: Wind, Bank of Jiangsu
Fig. 5 Effect of the 5-year FR007 swap hedge against 190208.IB
Source: Wind, Bank of Jiangsu
There are two other points to note when the IRS applies to hedge interest rate risk in the underlying asset, one is the duration/DV01 matching issue, and the other is basis risk. If the above IRS is used to hedge the 190406.IB bond (Nongfa 10 years), the hedging effect will be significantly discounted even if DV01 is matched on the portfolio construction date (see Figure 6). The first reason is that the use of 5-year derivatives to hedge the 10-year underlying assets has the problem of duration/DV01 matching, because the maturity of 190406.IB is 10 years, and its duration and DV01 decay rate are slower than those of the 5-year IRS and the 5-year CDB bond (see Figure 7), and after 4 years of holding the bonds, the DV01 of 190406.IB still has 69% of that of July 2019, while the DV01 of the 5-year IRS and 190208.IB are only 23% of the opening of the period respectively and 21%, if DV01 dynamic matching adjustment is not carried out during the coupon holding period, the hedging effect will get worse and worse with the passage of time. The second reason is basis risk. The price change of the 5-year IRS is not completely synchronized with the change of the yield of the 10-year agricultural development bond, and the DV01 matching can ensure that the valuation change is consistent when the interest rate of the derivative and the underlying asset changes by 1 basis point at the same time, but it cannot guarantee that the change in the interest rate of the derivative and the underlying asset is exactly the perfect match. In fact, the basis risk of a 5-year IRS and the underlying asset of a 5-year term is also present, but the basis risk is relatively small. The empirical results show that the correlation coefficient between the average fixed price of the 5-year FR007 interest rate swap and the yield of the 5-year CDB bond is 0.85, and the correlation coefficient between the average price of the 5-year FR007 interest rate swap and the yield of the 5-year CDB bond is only 0.67.
Fig. 6 Effect of the 5-year FR007 swap hedge against 190406.IB
Source: Wind, Bank of Jiangsu
Fig. 7 Changes in IRS, 5-year CDB, and 10-year Agricultural Development DV01
Source: Wind, Bank of Jiangsu
Summary and outlook
At present, in the process of market risk management in the field of investment and financing business, commercial banks have not fully applied relevant interest rate risk management tools such as IRS, and the support of relevant supporting systems, accounting rules for hedging accounting, and scientific and technological systems is lacking. In this regard, the author puts forward the following suggestions.
The first is to put policy first, and formulate management methods and institutional processes for interest rate risk hedging and hedging. Based on the overall situation of the bank's interest-sensitive assets and liabilities, it is necessary to formulate risk management strategies, set risk management objectives, and establish an accounting system.
The second is to continue to strengthen market research work, promote investment through research, and grasp risk control according to the market. Conduct forward-looking research and judgment on macro interest rates, grasp the direction and magnitude of interest rate changes in advance, and carry out IRS hedging business in a timely manner to avoid large fluctuations in the value of banks' proprietary assets.
The third is to further strengthen investment in science and technology, and realize intelligent and automated post-investment monitoring and management of the invested portfolio. When sensitive indicators such as DV01, duration, and basis deviate, the system can prompt and remind them in time and provide auxiliary decision support to help traders better manage interest rate risk.
Author's Affiliation: Financial Market Risk Control Department of Bank of Jiangsu, of which Wu Yue is the general manager
(1) 190208.IB: 19 CDB 08, 5-year CDB bond, value date July 2, 19, annual interest, coupon rate 3.42%
(2) 5-year IRS pegged to FR007: The relevant elements are the same as those in Table 3