The last three or four decades have seen a remarkable evolution in the institutions that comprise the modern monetary system. The financial crisis of 2007-2009 is a wakeup call that we need a similar evolution in the analytical apparatus and theories that we use to understand that system. Produced and sponsored by the Institute for New Economic Thinking, this course is an attempt to begin the process of new economic thinking by reviving and updating some forgotten traditions in monetary thought that have become newly relevant. Three features of the new system are central. Most important, the intertwining of previously separate capital markets and money markets has produced a system with new dynamics as well as new vulnerabilities. The financial crisis revealed those vulnerabilities for all to see. The result was two years of desperate innovation by central banking authorities as they tried first this, and then that, in an effort to stem the collapse. Second, the global character of the crisis has revealed the global character of the system, which is something new in postwar history but not at all new from a longer time perspective. Central bank cooperation was key to stemming the collapse, and the details of that cooperation hint at the outlines of an emerging new international monetary order. Third, absolutely central to the crisis was the operation of key derivative contracts, most importantly credit default swaps and foreign exchange swaps. Modern money cannot be understood separately from modern finance, nor can modern monetary theory be constructed separately from modern financial theory. That's the reason this course places dealers, in both capital markets and money markets, at the very center of the picture, as profit-seeking suppliers of market liquidity to the new system of market-based credit.
Treasury-swap Spread, a Puzzle
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Economics of Money and Banking
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Banking as Advance Clearing, continued
In the modern economy, the price of risk is determined in swap markets that distinguish specific forms of risk, most importantly interest rate swaps and credit default swaps. The Treynor model can be adapted to understand how the price of risk is formed in dealer markets.
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Perry G MehrlingProfessor
Economics, Barnard College
I wanted to start with the yield curve here.
This is called the yield curve.
As a way of motivating the topic for today, which is the swaps market,
interest rate swaps.
In a way, interest rate swaps are a kind private sector yield curve.
There a kind of corporate bond term structure yield curve.
And usually we think of the swap curve as being a spread over the treasury curve.
And this is the spread.
And people think of that as being, well if corporations are less creditworthy
than the government maybe, or there's less liquidity, or
people have different reasons why they think that there's a swap spread there.
What has happened in the world
since the financial crisis is that that swap spread has gone a little crazy, okay?
And is in fact off a negative at the long end and that's what I'm showing up there.
You see that this is data that I pulled off, this is data for today, okay?
This is showing you, the blue line is showing you the treasury yield curve.
And I'm connecting them with straight lines.
Just one year, five year, ten year, thirty years,
so you could smooth it out in your mind, but I only have four data points there.
And the important thing to appreciate is down there at one year, you can see that
the swap rate for, as I said I'm going to explain what the swap rate is, but
for the moment, this is like a corporate one year interest rate.
Is higher than the treasury rate.
There's a little spread there.
By ten years, they're basically on top of each other.
By 30 years, there's actually a spread that goes the opposite direction, okay?
The corporate swap spread is negative over treasuries.
And that means there's an arbitrage.
An arbitrage where you would short corporate bonds and long treasuries.
And why isn't somebody doing that?
So, this is what we're going to come to at the end.
This has been true, this negative swap spread,
this has been true basically throughout the crisis and ever since the crisis.
So, there's something seriously skewed in the structure of
the capital market, and this is a symptom, this is a symptom of.
But to understand that, we gotta understand a little bit more about what we
mean by a swap in the first place.
What do we mean by a swap?
I'm going to leave that there, and I'm going to write it here.
There is as often, in money markets and Wall Street, there's lingo here.
That we just have to get used because it's where the traders
have a monopoly and other people don't understand what they're saying.
So we have to get used to this and translate it into our balance sheets, so
that we're always sure exactly what they're saying.
I'm going to use, example.
She has an example, she talks about a AA firm and a BBB firm.
And we'll just call them AA and BBB.
And she is imagining that AA finds itself able
to borrow relatively cheaply at a fixed rate,
at a long-term interest rate.
And BBB by contrast is able to borrow
most cheaply as a flexible rate.
Short term, flexible rate borrowing.
So think of this as basically a bond.
AA is issuing a ten year bond, and
BBB is issuing three month LIBOR or something like that.
So that's the difference.
So triple B is worried that three months from now,
it's going to have to roll this over, and it doesn't like that, and
because it doesn't know what its funding rate is going to be.
It would like long term lending, as a matter of fact.
It would like to borrow long term in order to lock that in.
And perhaps AA is happy having shorter term borrowing, and so
they can do a swap, an interest rate swap, where they swap exposures.
Now, this is actually easy to understand now
because we always understand a swap as a swap of IOUs, and so you just have to say,
what are the IOUs that they're swapping, notionally, sort of behind-the-scenes?
What are these IOUs?
Well, if you want to swap into flexible right here,
what you need is a parallel loan structure where you have a fixed
rate, Fixed rate lending here.
That is the same rate as that, let's say.
And you have LIBOR on this side.
And if you're BBB, you want the opposite.
You want to get out of your LIBOR exposure and get into some fixed rate exposure.
And that is, that thing, where you're promising, here,
you're promising to pay a short term interest rate and
to receive a fixed rate for the life of the swap.
That's a swap.
You're promising to pay here, so this is just the other side of that.
You're promising to pay a fixed rate and receive a flexible rate.
That's a swap, interest rate swaps.
These swaps are quoted every day in the paper.
And it's in the second section and that's where I got those numbers.
I'll just show you here, and so it's down at the bottom of the second page,
interest rates swaps.
And they show them for various currencies euros, pounds, swiss francs, dollars,
yen and for one year, two year all the way out to 30 year and they quote a bid ask.
So, for example, for ten year they quote 1.66 and
1.69 bid ask, 1.66, 1.99.
So you can see that that's read ten year,
that's right about 1.66 there, 1.69 at swap rate.
That's this rate here.
What they're quoting is a swap in which there's, and
they could clear it in the footnotes, where it's six-month LIBOR on one side,
and maybe a ten-year bond rate, 1.66 on the other side.
That's an interest rate swap.
Now, the lingo.
I warned you about this.
Parallel loans, we understand I hope by now.
We know that whenever you hear the word swap
there is a parallel loan in somebody's mind.
And just once you understand what that parallel loan is,
you understand how the swap works.
In real life, there's not an actual parallel loan.
They're netting these payments, right?
So it's not that this is a liability, I'm paying you short of this rate,
and you're paying me that.
No, they're paying the net, okay?
And there's no actual loan, there's no principal there, so
it doesn't show up on your balance sheet.
It doesn't indicate increased leverage, or anything like that.
So it's just a swap, but like an off-balance-sheet kind of item.
But nonetheless, it has the same structure as this.
The person, AA, is referred to as the seller of the swap.
Sometimes said to be short the swap.
They are something that would be
more, I guess, more clear.
If you would be to say, they're the pair of a floating rate here.
They're paying LIBOR and receiving a fixed rate.
So BBB is the buyer of the swap.
Said to be long a swap.
And they're paying fixed, fixed rate.
So, if we were to put this swap on a balance sheet, the fact that street lingo
says this is short of swap, tells me we should put it here and put it here.
Just to follow that lingo.
There is no convention like this in actual balance sheets.
But since this is the lingo,
it seems this is the convention that people have in the backs of their mind.
So that's what I'm going to do in what follows.
Okay, so far, so good?
Now let me draw a few links to things we already know, so
that it will seem less strange to you.
If you think about this parallel loan structure,
you can see that an interest rate swap, a short swap position,
is like owning a bond and financing it in the repo market.
Financing it in the repo market,
short term financing of a long term bond.
So you own a bond and you finance.
See there? It's fixed rate there.
Flexible rate there.
So, it's like a repo.
A long term repo.
A repo in which you have a corporate bond here and you're using it as collateral for
a loan that's maybe six months, instead of over night or something.
But still, there's a kind of repo structure quality to it.
We call it a swap.
But it actually is quite similar to things we know already.
That's one analogy.
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