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To: Lucretius who wrote (7075)	2/4/2000 5:29:00 PM
From: Cynic 2005	Respond to of 42523

Educational material. ---------- prudentbear.com What the bond inversion means to swap traders. Posted By: Alphabeta <jaevans@altavista.net> Date: Friday, 2/4/0, at 3:52 p.m. While we speculate on the possible fallout of this week's bond market action, here is some food for thought. Interest rate Swaps and FRA's is not just about potential exposures to interest rate moves. Rather, the yield curve is sliced up into specific time buckets, and it is the forward rate that applies to each time bucket that represents the exposure on a swap curve. In practice, for example, a trader might pay a fixed rate on a 30 year swap and receive a fixed rate on a 10 year swap. Here, the trader is exposed to the forward interest rate for the 10 to 30 year period. Typically, these trades would be done Rho neutral, so the nominal size on the shorter dated swap would be greater to net off the overall rate risk. Given a move from a 6.75% 30 year yield and 6.00% 10 year yield, to a 6.00% 30 year yield and 6.50% 10 year yield, it is useful to consider the forward rate that our trader is exposed to. Initially, the forward rate is 7.00%. After the inversion, this forward rate drops to 5.67%, a 133 basis point move against the trader on a 20 year exposure! To put this in perspective, a $1m nominal exposure for the trader would produce a loss of over $110,000, or 11% of nominal exposure. That is a huge move for a position which is essentially a non-directional, interest rate hedge. Who knows the size of the positions out there? Swap derivatives are fairly unique derivatives in that it is future interest rate cashflows that are swapped. This requires no initial capital outlay, and very littleinitial credit exposure. Huge positions can be built with very little capital, and very little initial credit risk. However, moves such as we seen will produce a huge increase in credit exposures, since these derivatives are valued by summing the present values of future cash flows. The majority of investment banks would be on top of this type of correlation exposure, with more rigorous stress testing and more sophisticated risk management. They may not be quite as vigilant on the potential credit exposure blowups. Lesser banks, hedge funds, corporate treasuries, and insurance companies, however, may well overlook or be negligent of this type of exposure, since it much more difficult to stress and quantify correlation risks than it is to control outright exposures. It is not so much losses by major players that we have to fear but the mushrooming of credit exposures that major players may have incurred due to these extraordinary moves. The breaching of regulatory capital requiments and inability of smaller players to meet margin/collateral calls may be just some of the problems that have been encountered. [About that last line - it got me thinking; It is a piece of cake for AG to bail the suckers out! -ng-]