January 18, 2011
Ah yes, the holidays are finally over. You are back in your own home and comfort zone now, with fond memories of your extended family, all gathered together, opening gifts. The expressions of surprise and delight, all dutifully captured on your flip camera, made this season all the more joyful. But behind all the smiles and gratitude lies a simple, unspoken truth – that no one really got what they wanted! That brainy toy for Timmy? – too complicated!; that sweater from grandma? – too ugly!; and the must-have video game that 12 yr old Johnny even asked for by name? – too lame!; In December we graciously give and receive thoughtful holiday gifts, but before the new year begins we are already in full-blown “return it” mode, undoing countless hours of shopping, shipping, and sometimes shouting (good tidings, of course). If the holidays are marked by giving, then the post-holidays are marked by forgiving, as in, forgive me for returning this leopard-print Snuggie, but you leave me no choice!
We are generally quite familiar with return policies for household goods, clothing, and electronics, but what about derivatives? How do you return a swap? What if I don’t like the price? How do you handle a funding charge (aka “restocking fees”)? Just like your experience with consumer returns depends on the business and its policies, so too your experience with derivative unwinds will depend on the bank and your documentation, as well as prevailing market norms. But before you can know if your experience will be hassle-free or harrowing, you first have to ask for an unwind indication from your counterparty.
Price check! Your counterparty is there to make a market for you on the derivative transaction you need. A termination is just another transaction (albeit in the opposite direction), and as such will also be subject to a bid-offer spread, just as it was at inception. It should go without saying (but we will say it) that if your position is an asset you should expect to receive something less than the mid market value, and if your position is a liability, you should expect to pay something more than mid market value, at unwind. The underlying economics (strike, notional, maturity, etc.) will dictate the derivative value, but the bid-offer on your transaction, which is a function of your counterparty’s own trading costs and profit expectations, will determine the final price of the transaction. Chatham clients are familiar with our ability to model and value their derivatives, and thus see how their counterparties price transactions – on the way in and on the way out. On most occasions, the unwind price is reasonable relative to the mid market value, and you go ahead and unwind. But if you do enough transactions you will eventually see that one trade that cannot be unwound with your counterparty close enough to mid for your liking. What do you do then?
Pick your battles! First, remember you can win the battle but lose the war. Your derivative value is constantly moving, and even more so in a volatile market. We can narrow the unwind price by 2 basis points (bps), only to see the market value move against you by 5 bps. This delicate balance is always at play and should be considered carefully on any unwind. But in a stable market where your main concern is the dealer price relative to mid, you still have a few choices that can reduce the price for you. We just mentioned how a termination is like any other transaction. However, if your counterparty gets a sense that this trade was your only business, and this termination is the end of it (one and done), then they are less likely to improve on a poor unwind price. That’s not to say that all one-trade relationships are subject to higher unwind fees; that is certainly not the case. But future business (at least the possibility of future business) can be an important part of getting a fair unwind price from your counterparty. Chatham would discuss the fees with your counterparty to understand their pricing objective. A wide unwind price can sometimes be narrowed in this manner, especially when we agree on all other aspects of the value of the trade, and demonstrate quite clearly that we see more in the unwind price than is typical for the current market. But even when the marketer is willing to reduce the unwind fee, the discussion can reveal other components in the price that are out of his or her control.
Expose hidden fees! A constructive discussion on fees may reveal that in certain markets your counterparty will assess a “funding charge” at unwind, in addition to the bid-offer on your derivative. The logic behind the funding charge is as follows: The bank was receiving a fixed swap rate and paying 1mL, with the prospect of maintaining this flow to maturity. You elect to pay them now, the PV of all expected future cash flows, which throws a monkey wrench in their plans. Now they have to deploy this new found money in the business, and even though in the future it will be lent back out to another company at attractive rates, at present it will only earn fed funds or something equally paltry, until it’s redeployed. Unbelievably, the same logic applies if you are owed money (you are unwinding an asset position) because the bank needs to temporarily borrow money from the business (at prevailing rates) to make you whole. Funding charges are generally constrained by competition, meaning when banks are successful in doing this, they all will, and when banks begin to reduce or eliminate these charges, others follow suit.
Return it…to a different counterparty! So, we have reviewed and de-constructed the unwind price with the bank on your behalf, and we are at a point where no further discussion will reduce the price. Maybe your counterparty was intentionally tight at trade inception, only to show wide pricing to you, a captive “price-taker,” at unwind. What to do now? You can’t return your Wal-Mart purchase to Target in the consumer world, but you can transfer your derivative position to another bank, and unwind with the new bank, in the OTC derivatives world! This is called a novation (aka, transfer or assignment), and requires consent of the transferor (you), the transferee (new bank), and the remaining party (current bank). Note: this is but one example, there are other approaches. The reason you would transfer in this scenario is that the new bank agrees in advance to take the trade and unwind with you at a much more favorable price. For large transactions, this is a viable alternative, but for small trades this approach is generally not worth the hassle. Important other aspects come into play, including whether you and your current counterparty can even face the new counterparty in a trade or not. Also, consent is required, meaning that nothing happens unless all three parties agree, but Chatham works to ensure transfer is not unreasonably withheld or delayed wherever possible. A successful transfer can result in you terminating at a far more reasonable price, and may be considered when other approaches are exhausted.
January is already packed with holiday returns, so adding a cap or swap unwind to your list can be a big hassle. If you are faced with unclear or unreasonable unwind pricing, give us a call! Chatham can provide you with price transparency and negotiate a fair unwind price on your behalf, any time of the year!