Caps off in London
4
investment banking
What'S NewS Issue 2 February 1997
wK
The financial engineering arm of the London-based investment banking unit is
emerging as a centre of competence for the entire global network. It is deeply
involved in the development of innovative new financial products - among
them exotic interest rate instruments - and has also developed sophisticated
new mathematical models that can be used to accurately price such instruments
and their associated risks. What have they got for us and how can we use them?
What's NewS asks for details.
Mark Blundell and
Brian Coffey (left)'
...we're willing to
inform any cliënt
about any product
witb an ultimate
view towards getting
more deals done'.
(Philip Hess is
missing from the
picture
The sophisticated interest-rate based
products feed into and support other
activities of the bank. Together with a
variety of liability management instruments
- such as special interest-rate caps
frequently used to complement a 'plain
vanilla' base - they are intended to appeal
to bank clients like asset managers,
institutional investors and private
individuals. 'Even though we're a triple-A
rated bank, until recently we couldn't offer
our clients anything like this,' remarks
Brian Coffey, senior manager financial
engineering. 'Now, we have more arrows in
our quiver.
SWAT CAPACITY
'Here in London we consider ourselves part
of a derivatives "SWAT" team - we do the
Special Weapons And Tactics - and we're
INNOVATIEVE
FINANCIËLE
PRODUCTEN
Londen ontwikkelt
speciale producten voor Investment Banking.
Het FE-team is druk bezig met geavanceerde
rente-instrumenten voor asset managers,
institutionele beleggers en private clients,
zoals 'reduced premium cap','flexible cap',
'chooser'en 'Bermudan swaption'.De tege
lijkertijd ontwikkelde rekenmodellen zorgen
voor een scherpe concurrerende prijs.
willing to do internal marketing and inform
any cliënt about any product with an
ultimate view towards getting more deals
done. This is why we have developed a
consistent yield curve methodology in 19
currencies.' Moreover, he says, with a
'reduced premium cap' and a similar
'flexible cap' or 'chooser' long offered by
other banks, 'our salesmen can now go to
clients and say: "yeah, we can do that too -
and we can do it competitively".'
MULTI-APPLICATION
More innovative is the 'Bermudan
swaption' - an option on a swap that can
be exercised on a finite set of dates. For
example, for an ordinary three month
European option on a swap, the option can
be only exercised once; an American option
can be exercised at any time over the three
months. The Bermudan 'swaption' might
be exercisable only every two weeks - and
thus stands somewhere in between. 'This is
also a component of quite a few callable
bonds in the market that we might want to
asset swap into pure floating rate notes - in
which case we'd have to strip out that
Bermudan feature - and it could also be a
component of some of the issuing that we
might want to do for other corporates in
the future,' says Coffey.
HIGHER RATES
LIBOR Range Accrual products allow an
investor to accrue a higher than market
interest rate for every day that LIBOR
settles within a given range; when LIBOR
settles outside the LIBOR range, no interest
is paid. Thus, the investor is given an
opportunity to take a LIBOR view on the
market's direction; he receives a higher
(nominal) rate, but only if his view is borne
out in fact. The investor is in effect selling
away some of the probability built into the
interest rate curve of higher rates occurring,
and the product thus forms part of the
ongoing general process of bundling and
unbundling financial products. Such
products are often components of
structured notes; originallv developed to
support our asset packaging desks, they are
also attractive in their own right to
investors where rates are low (like Japan).
NEW OPTIONS
Another relatively-innovative family of
products include 'periodic' caps and floors,™
in which the increment of the interest rate
over a fixed period is capped. For example,
if LIBOR stands at 7 percent, you have a
50 basis point periodic cap, and two
months later LIBOR set at 8 percent, you
still pay only 50 basis points more. 'This is
more a product for the investor community
than the hedging community,' according to
Philip Hess, also of financial engineering.
London is approaching building societies in
the UK with a view towards structuring
mortgages with this, he says, which creates
'the possibility of mortgage products that
stand somewhere between regular fixed-
rate and floating-rate mortgages, as they do
in the US.'
SUPPORT FUNCTION
'Although we definitely see a marketing M
support role locallv in Europe, we primarilji
see ourselves supporting the bank globally,
in a technical sense, by making our
products and spreadsheets available
throughout the network,' says Hess. 'It's
not realistic for us to do marketing support
and talk to clients on a regular basis in
New York, Singapore, and Frankfurt -
eventually they'11 develop local expertise of
their own. But we feel that the development
of our arsenal of generic derivatives - and
creation of the mathematics - should be
relatively centralized in Europe.'
Note: A five-year plain vanilla cap on 6 month
LIBOR has nine options or resets. The reduced
premium cap allows the investor to exercise only
a fraction ofthose nine and 'has been a popular
product since the corporate hedger typically
discovers that the early options in the plain
vanilla cap expire worthless/explains Coffey.
'One alternative is to buy a forward start cap, but
that's necessarily more expensive. Plus, if interest
rates do spike up early on, he has no protection,
whereas with our product he has it ifhe needs it.'
