When pitchers and catchers reported for spring training two weeks ago, sleepy baseball fans across the land awoke from their sports hibernation to the first real sign that spring was upon us. Meanwhile, in Philadelphia, the fans were not just awake but already fanatical, having not slept a wink since General Manager Ruben Amaro Jr. brought Mr. Lee back to town during the offseason. The Phillies have now assembled the most fearsome foursome in all of Major League Baseball, with their starting rotation being compared to the greatest pitching staffs of all-time (the ’03 Yankees, ’66 Dodgers, ‘95 Braves, ’71 Orioles, and ’54 Indians, among the probable top 5). With Cy Young award winners Roy Halladay and Cliff Lee leading the way, and post-season MVPs Roy Oswalt and Cole Hamels rounding out the top four, the Phillies are a lock to capture the NL Pennant this year. And now that the media have also crowned them pre-season champs, it’s a foregone conclusion that the Fightin’ Phil’s will bring home the World Series title, right? Hmmm. Better check the eurodollar forward curve.
Eurodollar forwards (ie, LIBOR)? What on earth does that have to do with baseball? Well, if you’ve ever been pitched a swap, then you know it can gain or lose value over its life, depending on what happens to the LIBOR rates along the way. Just as actual LIBOR rates won’t match the forward curve that was predicted at the inception of your derivative, so too the Phillies march toward a championship is unlikely to follow expectations either. How many games will they win? Who will they beat, and on what dates? If the Phillies do make the World Series, their path to the post-season will have been exciting but downright difficult to accurately predict. In baseball and derivatives, no one can say with certainty how the season or your swap will unfold.
Construction. The forward curve is generally constructed using inputs of actual LIBOR fixings for the short end of the curve, eurodollar futures contracts for the middle part of the curve, and swap rates for the long end of the curve. Swap rates and eurodollar futures are constantly changing as a result of trading during market hours, while the daily LIBOR fixings in tenors from overnight out to 12 months are set 11AM London time on every good business day. From these inputs, a eurodollar curve is ‘bootstrapped’ to come up with the predicted forward rates for any date in the future. (There is also a basis adjustment from 3 month to 1 month LIBOR, but that’s for a future newsletter!) The resulting curve tells you where the market collectively thinks LIBOR will fix for any given reset day out to the maturity of your swap.
Application. The forward curve is dynamic, meaning that it constantly changes before and after the execution of your derivative. In a pay-fixed swap, you agree to pay a fixed rate of interest over the life of the instrument, and receive back a floating rate of interest based on the actual LIBOR fixings that occur. The swap rate is calculated such that the present value of all future cash flows on the fixed leg of your swap equals the present value of all expected future cash flows on the floating leg of the swap, prior to any credit charge and bid-offer spread being applied. Once this rate is locked in, the swap will gain or lose value according to how the actual eurodollar forward curve moves for the remaining life of the swap. If you are paying fixed, the swap gains value if the forward curve shifts upward or steepens. The swap will lose value if the forward curve shifts downward or flattens. The value will change nearly every second of every trading day, until the swap matures.
Reality. The eurodollar forward curve is a snapshot today (this instant) of where LIBOR rates are expected to be on a given date in the future. But actual rates are all but guaranteed to be higher or lower than predicted. Although the swap’s value is based on the predicted LIBOR forwards remaining at any point in time, in each period you will receive the cash flow that is based on the actual LIBOR fixing for that period. One way to compare the two is to plot actual LIBOR fixings realized during the life of your swap, versus the predicted LIBOR forwards at the inception of your swap. If you were to then consider what the forward curve looked like at various other points in the life of your swap (say, quarterly, for example) then a plot of these many forward curves versus the actual LIBOR fixings realized during the life of your swap would produce a graph known as a “hairy chart.” The chart is a visual reminder of how the market’s collective expectations rarely, if ever, come to pass as predicted.
So, what about the Phillies chances? Well, they are probably really good; after all, they have the best pitchers in baseball! And yet, of the top five all time rotations mentioned above, only one went on to win the World Series that year. Terrible stat, I know, and that should not bode well for the Phillies. Ah, but fortunately baseball and derivatives share one more important characteristic worth mentioning: past performance is no guarantee of future results!
If you have questions about baseball or derivatives, give us a call! Whether its legendary pitching or LIBOR fixings, our passion for these pass times is second to none!