Learn the Lingo (Rates)

It seems the "Learn the Lingo" series has been quite popular, so I figured I'd add to it in various product spaces. Today we do "rates," which usually refers to swaps. Swaps are extremely interesting, extremely versatile and surprisingly confusing.

As always, if you have any questions feel free to e-mail me (or check Wikipedia). It might be worth reading the "Learn the Lingo (Sales & Trading)" post before you read this one if you haven't already. Use the archives, it was one of my first posts.

Here's a primer that would cover what you might learn your first week on the "rates" desk:

Libor - London InterBank Offer Rate. This is the rate banks charge each other for inter-bank deposits in London. This is used as a benchmark floating rate for a lot of stuff. Permutations include "Euribor," which is the Euro interbank offer rate.

Eurodollars - Dollar denominated deposits at banks not regulated by the Fed (so outside the US). The eurodollar rate is the interest rate on these deposits. The eurodollar rate is important as it signifies the dollar interest rate free of Fed regulation. Don't confuse Eurodollar with anything having to do with Europe. It doesn't have that much to do with Europe. Permutations include "Euroyen," which is the deposit rate for yen denominated stuff outside Japan.

Eurodollar Futures - These are important enough that I figured they deserve their own post. These are futures on the Eurodollar rate. They are priced as 100-Rate. So if the Eurodollar rate is 5.25% on the future's maturity date then the price of a Eurodollar future is 95.75 at maturity. Of course, futures for future dates include a good bit of speculation. These are a fairly good proxy for the risk-free rate expected starting a given date (as libor is a good proxy for risk-free rate and Eurodollar trades with a slight adjustment to libor).

IMM Date - These are the days on which Eurodollar futures expire. There are monthly expiries, but the important ones are March (H), June (M), September (U) and December (Z).

Packs - packs refer to sets of four representing one year. The front pack, consisting of the first four eurodollar futures is called the "white pack." The next four are called the "red pack." Then green and blue after that. The rest have colors too (purple, pink, silver, copper etc), but the first four packs are really the only liquid eurodollars.

Bundles - bundles refer to all the eurodollars up to the given pack. So the green bundle would be the green, red and white packs all together ("bundled" up).

counterparty - the guy on the other end of a trade.

bp - pronounced "bip" refers to basis points. A basis point is one hundreth of a percent. So 5.7525% interest rate is 575.25bps or 575 and 1/4 bps. Most rate instruments are quoted in bps.

tenor - the length of a swap. A 5 year swap lasts for 5 years and is considered to have a 5 year tenor. The payments will occur as schedule for 5years until the swap matures.

settlement - most things in the fixed income world trade on one day and "settle" two days later. So all the maturities and coupons are priced off the "settle" date instead of the trade date.

maturity - maturity is when the last payment is scheduled.

Fixed-Float swap - also known as just "swaps" or "vanilla swaps." These are the basic building block of the rates world. One side pays a fixed rate and the counterparty pays a floating rate (usually libor). These are quoted by the fixed rate, the amount is either in notional or pv01 (present value of a 1bp move in rates, sometimes called duration in practice) and buyer pays fixed. So, "67 1/4 bid 100 5year rates" means "I want to pay fixed on a 5year fixed-float swap at 5.6725 for 100 thousand dollars per basis point." Note that the big figure (5) in the rate was omitted when quoted because it's assumed that everyone knows the big figure rate. In the US the convention for these is 3month semi-bond, which means the fixed payments happen "semi-bond" style (semi-annually, like a bond) and the float payments occur on 3month libor resets.

payer swap - refers to a swap in which I pay the fixed rate. Note, the convention is that buyer pays fixed.

receiver swap - refers to a swap in which I receive the fixed rate. I refer to these as "I" pay fixed because my payer swap is my counterparty's receiver swap and visa-versa. People also refer to receiving fixed on a swap as "giving" the swap, which means to "sell" the swap. Again, remember that buyer pays fixed.

MMS - matched maturity swap. Just like it sounds, it is a swap who's maturity matches something else. This often happens when you are trying to synthetically hedge a bond (CT5 MMS refers to a swap that matches the maturity of the on-the-run 5year treasury note).

Basis swap - these are a float-float swap. They usually refer to some basis vs libor. It can be the fed funds rate to libor basis, the basis of a treasury future, or what have you. These are mostly flow oriented, and I have yet to see a really good pricing algorithm for these. They seem like they ought to have some good "fair value" pricing algorithm though.

Swap spread - the swap spread is the spread of the swap rate over the treasury rates. So if 10yr treasury is trading at 5.1725 and 10yr swap is at 5.8225, then the spread is 65bps. People do trade the swap spread frequently.

Yield curve - the curve made by plotting swap tenors against rates. The treasury yield curve shows treasury rates over the different tenors (2yr, 3yr, 5yr, 10yr, 30yr and some interpolation in between). The "yield curve" generally refers to the swap rates curve though. Usually the short end is plugged by eurodollar rates.

Forward curve - a yield curve built in "forward space." So if I was to price today all the swaps starting in 1year (i.e. 5yr 1yr forward refers to a 5years swap that begins payments in 1 year, so effectively I'm locking in a rate for something that doesn't start for a year), then I would have the swap curve I expect to see one year from now.

curve trade - curve trades are trades that bet on the slope of the yield curve. In swaps, for example, a 5s10s curve trade would involve a receiver 5yr swap and a payer10year swap (which, if you think about it is a "steepener" -- a trade that bets on the slope getting steeper). You can also do curve trades in treasuries, eurodollars, MBS, etc. Curve trades are usually (but not always) done duration or dv01 neutral.

Rate switch - refers to a swaps curve trade. In curve trades, buyer puts on the steepener, so "50 offer 14 and a half 5s-10s rate switch" or alternately "my flattener 50k/bp at 14 and a half" means "I want to put on the flattener (sell the curve) at 50 thousand dollars per basis point at 14.5 bps differential between the 10s rate and the 5s rate."

Butterfly - butterfly trades are three legged trades where the two "wings" go one way and the "belly" goes the other. A typical rates butterfly is the 2s-5s-10s fly. So if I were "buying" this fly, then I would be paying the 5year fixed rate and receiving the 2s and the 10s fixed rates. There are various weightings for this, which I will not get into here.

There are an infinite number of details to go through in swaps land, but this is probably enough to sound intelligent your first few days.