Wednesday, June 27, 2012

The Bank Fee Paradox: Can Less Be More and More Be Less?

We ended our last post, “The Key to Understanding How Your Banker Thinks is a 4-Letter Word”, with the question about whether or not it is wise to “beat your bank down” on fees.
While everybody likes to save money, when we look at our banking relationships from a holistic organizational perspective, things can become a little more complicated.

It is Possible To Lower Our Bank Fees
If we have opened up a copy of our favorite finance publication in the past year, be it Treasury & Risk, CFO, the AFP Exchange, etc., chances are there will have been an article or some advice about reducing the fees we pay to our bank.
We can do this in a number of ways.
·         We can bid out the business using a Request For Proposal (RFP) process at regular intervals, such as every three years or so.
·         We can use market studies such as Phoenix-Hecht’s annual reports or the Association of Finance Professional’s resources as a way to determine where fees are out of line and negotiate our fees down.
·         We can use third party firms, who have their own fee databases, who will evaluate our banking activity and are compensated through a percentage of the fee reduction they obtain.

There Are Powerful Incentives to Lower Our Fees
Any of these approaches will likely result in reduced fees, and there are a number of factors which encourage us to undertake this endeavor.
First and foremost is the fact that fee reduction is tangible. We paid x last year, and we paid y this year (y being lower than x), and therefore we saved x - y. The numbers are on the page and cannot be disputed. We have proof that we have done a good job.
Secondly, there is often the organizational push to “beat the budget”. The leadership approaches the business units and support areas with the “The year has been tough so far, can you give me an extra 1%, or 3%, or 10% cost reduction so we can still hit our performance targets by year end?” Bank fee reduction, usually one of the significant Treasury budget line items after personnel, is a tempting pot from which to meet this challenge.

Let’s Review RAROC
Some would claim that the Treasurer’s job #1 is “Don’t run out of cash”. Part of how we accomplish this is to rely on a certain amount of credit capacity so that we have sufficient liquidity and capital available for the needs of the business during the course of the year. That being the case, it is crucial that we consider things from the bank perspective in order to secure this source of funding.
As discussed in “The Key to Understanding How Your Banker Thinks is a 4-Letter Word”, banks utilize RAROC (Risk Adjusted Return on Capital) models when making their credit deployment decisions.
One way we can put ourselves in our banker’s shoes is to work the RAROC process in reverse. We can calculate our credit capacity as follows:
·         Figure Out What You Spend with the Bank - Let’s say that we spend in total ²1 million per year on banking activities with our bank or banks (for those new to Treasury Café, the symbol ² stands for Treasury Café Monetary Units, or TCMU’s).
·         Estimate What Goes to Their Bottom Line – Through industry studies and our network of contacts, we believe that the bank’s margin on these products is about 50%, so ²500,000 goes to the bottom line.
·         Estimate the Amount of Capital Our Bank Holds Against Our Credit - Finally, through a thorough review of Basel III and our country’s banking regulations, we know that the bank needs to hold 15% of capital against their line of credit to us.
·         Determine an Acceptable Return on Capital for Our Bank’s Investors – through a market and cost of capital analysis, we calculate that our bank needs to earn at least 11.11% on their capital (though of course they will tell us they would like to earn more!).

Figure A
Putting all of the above together, our bank will extend us ²30 million in credit. The calculation is shown in Figure A.

What’s The Catch?
So what is the problem with all this?
Let’s say that for our organization the ²30 million in credit is exactly what we need.
The following day our CFO comes around, after having been badgered by HR, IT and others that those other departments have contributed more budget cuts than the finance and accounting group, and insists that we look at cutting our bank fees.
We dutifully call up the bank, throw reams of fee data at them, threaten them with an RFP, and consequently they reduce their fees by 10%, so that we now pay ²900,000 annually for their cash management services.
Now our CFO can hold his/her head up high at the next meeting with the other organizational groups. “Hey, I contributed a ²100,000 reduction to our goals!”

Figure B
However, when our line of credit comes up for renewal, our bank is unwilling to extend us the ²30 million we require. Should we be surprised? Figure B tells us we should not. Given our tendency towards fee reduction, the bank will put some buffer into the number calculated, and will say that ²25 million is the most they can do at this time.
While we have cut our fees, we now do not have the credit we need to conduct our business.

Can Paying More Fees Reduce Costs?
What this example shows is that there is a trade-off between credit capacity and bank fees.
Absent any line of credit, in order to ensure adequate liquidity is to set aside cash in a “rainy day fund”. Since this is permanent, we can look at this through a combination of debt and equity issuance.
Looking at our ²5 million gap due to our fee capacity, if we have an 8% weighted average cost of capital (the cost of both debt and equity at our “target capital structure”), then raising this will cost us ²400,000 annually to raise our liquidity need. This would be offset by the return on investing this cash, since we would have it most of the time unless we experienced the “rainy day”.
At today’s rates, this return would be negligible, perhaps ½%, so we might earn ²25,000 per year on investing this cash.
As discussed in our last post, a line of credit will cost a market rate comparable to our Credit Default Swap rate, so for sake of this example let’s say that is 4%. If we could raise this in credit it would cost us $200,000.
Comparing the two:
·         Cost of Financing Alternative – ²375,000 (²400,000 cost of capital – ²25,000 investment return)
·         Cost of Credit Facility – ²200,000
·         Difference – ²175,000
Now let’s compare this to the last section. In that, we saved ²100,000 annually by beating our bank down on fees, though this will cost us credit capacity.
Replacing this credit capacity will cost us ²175,000, so in aggregate we pay more than if we had left the bank fees alone!

Caveats
So why isn’t everyone running around increasing the fees they pay to banks in order to secure adequate liquidity?
Some of the reasons are:
The Balance Between Short-Term and Long-Term - Line of Credit Agreements are usually for a set term, so the credit capacity you give up does not occur right away, but sometime in the future. For this reason, if the immediate need is short-term cost reduction, bank fees are fair game because the increased cost offset of obtaining more liquidity discussed in the last section does not happen until later.
This is Not an Exact Science – RAROC calculations require a number of adjustments, each of which may be “tweaked”, so there is no such thing as an absolute minimum hurdle to get across.
It’s All About the Future – The banking relationship is somewhat long-term in nature (with most bankers, anyway). Thus, the bank will have some willingness to earn sub-optimal returns in expectation of a bonanza later. One means corporations have at their disposal to accomplish this is capital market deals. They may happen sporadically, but the fees on these can make up for years of skinny returns.
Bankers are Dime a Dozen – if we have a bank that dials back their credit commitment, new banks may be enticed to take their place, and face it, there are plenty of fish in the sea. Getting a new bank on-board will require the future potential of fees but there is an acknowledgment that this will take time to occur. After 4 or 5 years, if it doesn’t pan out, they drop you and a new bank takes their place, all gushy about the new relationship with stars in their eyes. After 4 or 5 years….

Key Takeaways
Bank fees cannot be taken in isolation, they need to be viewed in a holistic organizational context, with the understanding that there is a relationship between fees and credit capacity. Because there are mitigating factors and the time required for this relationship to fully play out occurs over many years, it can be easy to lose sight of this relationship or reduce its priority in favor of other more pressing items. However, to those that possess the desire to establish honest, straight-forward, win-win long-term relationships, it is a dynamic that needs to be carefully considered.

Questions
·         How important is the long-term relationship to you versus other short-term objectives?
·         Which of the caveats are most important to you or your organization?
·         How much credit does your organization require vs. its capacity to support it through fees?

Add to the discussion with your thoughts, comments, questions and feedback! Please share Treasury Café with others. Thank you!

Friday, June 22, 2012

The Key to Understanding How Your Banker Thinks is a 4-Letter Word

The banking relationship is critical to any business that relies on bank credit for their liquidity, working capital, and financing needs. Without this access to credit, the business may at be unable to meet its current obligations and face bankruptcy and liquidation, or be forced into a mode where it cannot take advantage of growth opportunities and/or pare back its existing operations.
Because of this, there is a dynamic involved whereby the bank has seemingly a lot more power in the relationship than the business. After all, the bank does not go out of business if they do not provide a loan or line of credit to us. They go on their merry way with seemingly endless funds stuffed in their coffers.
If we are able to get past this seeming discrepancy, we can help put ourselves in a better position to make our bank relationships a lot more productive and a lot less discomforting. Putting ourselves in our banker’s shoes is one way to go about doing this.

Banks Are a Business Too
One critical thing to understand is that a bank is a business too. While we might imagine all our problems would be solved if we had billions at our disposal to dispense as we saw fit, for the bank this is the central business question.
These billions are actually liabilities on the banker’s balance sheet. The funds that they acquire come from deposits in various products such as checking accounts, savings accounts, money market accounts, short-term loans, long-term loans and equity.
A loan or line of credit supplied to a business is an asset from the banks point of view. And just like any business, it needs to earn enough on its assets to provide an acceptable rate of return to its investors.

Bank Capital Requirements
For every loan a bank makes, be it to a company, a consumer credit card account, etc. it is required to keep some funds in reserve to provide a buffer or cushion against losses. Often this buffer has a mandated minimum that is set via the regulatory process.
The newest regulations coming into effect with respect to this are the Basel III accords. These specify a series of capital requirements that are going to be phased in over the years until 2018.
We are not going to delve into Basel III at this point because it’s not really required to understand a banker’s thinking from a strategic perspective, which is the aim of this post.

Example
So let’s take a simple example. Bank X provides a line of credit to Farmer Joe’s Agricultural Empire in the amount of ²1 million (the symbol ² stands for Treasury Café Monetary Units, or TCMU’s) in order to provide working capital funding. It is a 5-year credit facility.
Given the credit rating of Farmer Joe’s and the assessment of Loss Given Default (LGD), Probability of Default (PD), and Exposure at Default (EAD), the bank is required to hold 15% of its equity capital against this line of credit.
Bank X charges Farmer Joe’s 2% annually for this credit facility. Given Farmer Joe’s credit rating, its Credit Default Swaps currently trade at around 2% as well (for information on pricing Credit Default Swaps, see “Into the Belly of the Whale: Hedging and Credit Default Swaps”).

A Necessary Tangent on Arbitrage and Market Pricing
The fact that the credit facility costs and the CDS pricing is the same is not a coincidence – if there was a big difference between the credit facility cost and the “market” there would be an ability to arbitrage, which would ultimately lead to a narrowing of the price gap.
Why is this the case? If Bank X were to propose charging Farmer Joe 5%, while CDS prices were 2%, Bank Y would come along and propose to Farmer Joe that they will give him a Line of Credit for 4.75%. Since CDS prices are 2%, Bank Y would net 2.75% risk free by turning around and selling this exposure in the CDS market. Bank Y would end up with no exposure to Farmer Joe (since it sold the exposure in the CDS market for 2%), while receiving 4.75% by providing the credit.
Seeing the chance for “free money”, Bank Z would gladly provide Farmer Joe with credit for 4.5%, since it could offload this risk onto the market for 2%, and therefore get 2.5% of money-for-nothing in the transaction.
You can see where this is going – any bank offering credit to Farmer Joe above the market price of the credit risk will be undercut by another bank, since free money in any amount is attractive.
Conversely, the number of banks offering Farmer Joe less than 2% for the line of credit will be few, as they will be locking in a loss on the provision of credit versus the cost of that credit in the market.
So because there is a market, the cost of credit is generally set via the classic Supply and Demand curve as depicted in Figure A. The pricing occurs where the Demand for Credit (line “D”) intersects the Supply of Credit (line “S”).

Getting to the Four Letters
Given that Bank X is required to hold ²150,000 of equity against its line of credit provided to Farmer Joe, and knowing that its equity investors require some sort of economic return on their investment, Bank X will calculate a Return on Capital just like any other business would do.
Since the amount of equity it is required to hold depends on the risk of the loan, the acronym most important to the bank from the business perspective is the Risk Adjusted Return On Capital, or RAROC (the acronym has 4-letters, one is used twice).
If real estate is "location, location, location", the banking business is "RAROC, RAROC, RAROC".

Something Does Not Add Up
But wait…in the prior section we just determined that Bank X will charge 2% because the market cost of credit is 2%, so this is a wash. Where does the bank earn its return?
The RAROC calculation the bank performs is done on the basis of relationship or product. An example of relationship would be their line of credit with Farmer Joe’s Agricultural Empire. An example of product would be a consumer credit card business.
Since Bank X provides Farmer Joe credit, and there is a strong relationship between the two institutions, Farmer Joe does its cash management activity (checking accounts, investment sweep accounts, etc.) with Bank X as well. Let’s say that this activity results in fees being paid to Bank X every month in the amount of ²3,000.
Let’s go on further to say that Bank X’s costs associated with this cash management business (IT, personnel, taxes, etc.) is 50%, or ²1,500. Thus, ²1,500 goes to the “bottom line” (²3,000 - ²1,500). Annually, Bank X earns ²18,000 on its banking activity with Farmer Joe.
Bank X’s RAROC is therefore 12% - calculated by its net earnings of ²18,000 divided by its capital deployed of ²150,000 (from the line of credit).
What would be Bank X’s RAROC if Farmer Joe did not do its cash banking with Bank X? As established earlier, since the provision of credit will generally offset the market cost of that credit, there is nothing that goes to the bottom line for that activity, therefore it would be ²0 divided by ²150,000, or 0%!

Imagine You are a Bank Investor
If you are an investor in bank stocks, which bank would you want to buy shares of: Bank X, earning 12% on its equity, or Bank Y, earning 0% on its equity?
The critical distinguishing feature we introduced in the last section, and the reason we go from 0% to 12% return on equity, is the fact that Bank X is doing other banking activities with Farmer Joe’s that does not require capital but earns fees. In the banking world this is known as “ancillary business”.
Because lending requires the bank to set aside equity, banking activities that require this “use the bank’s balance sheet”. There is only so much equity on the bank’s balance sheet that it can use, so this is a finite resource for the bank.
On the other hand, the ancillary business the bank performs is not restricted by the balance sheet, so the crux of the banking business hinges on maximizing the ancillary business vs. the use of the balance sheet.
Imagine yourself as an investor again. If two banks each use ²1 billion of their balance sheet, then the bank that derives more income from ancillary business than the other will be the more profitable, and the one you will want to invest in (all other things being equal).
This being the case, Bank X, faced with the choice of lending to one of two companies, will lend to the one where the chance of ancillary business is higher and will not lend to the one where the chance is lower. This is how they maximize the use of their balance sheet.

Implications
Now that we understand the RAROC concept, and how this drives a bank to maximize the ancillary business vs. the use of the balance sheet, we can understand some of the thinking that occurs.
When Congress passes laws restricting late fees on credit cards, this causes the ancillary business to be lower. What must the bank do to stay even? Either find new fees to charge to offset what they are losing, or curtail the use of the balance sheet (e.g. lending) to keep the ancillary business vs. balance sheet ratio the same.

Key Takeaways
Banks, in order to earn adequate returns for their investors, seek to maximize the generation of ancillary business opportunities given their balance sheet capability.

Questions
·         If credit is vital to your business, does it make sense to "beat your bank down" on the fees it charges?

Add to the discussion with your thoughts, comments, questions and feedback! Please share Treasury Café with others. Thank you!

Saturday, June 16, 2012

Into the Belly of the Whale: Basis Risk

In our last post, “Into the Belly of the Whale: Curve Balls”, we looked at the term structure of the probability of default and looked at how a “curve flattener” trade pays off when the term structure flattens.
We now apply this knowledge to some of what has been proposed with respect to JP Morgan’s derivative activities and derive some lessons that we can take with us.

It’s a Hedge After All
According to Matt Levine’s assessment, JPMorgan had a significant amount invested in debt securities of other firms.
We have already examined how to price a Credit Default Swap in “Into the Belly of the Whale: Hedging and Credit Default Swaps”.
Figure A
In theory, we can price a bond using the risk free rate if we know the same factors that go into the Credit Default Swap calculation – default probabilities and recovery/loss rates. Figure A shows this expected value calculation in “tree form”.
Using this methodology, the upper leg of the tree is worth $999,519 ($1,050,000 x (1 - 1%) x 0.962) and the lower leg is worth $4,038 ($1,050,000 x 1% x 0.962 x 40% recovery rate), for a total expected value of $1,003,558. This compares to a risk-free bond (i.e. a bond that will pay out with 100% certainty) valued at $1,009,615 ($1,050,000 x 0.962).

Figure B
The difference between the risky bond and the risk free bond price is $6,058. Figure B shows our Credit Default Swap pricing calculation, which comes to the same amount - ah, all is right with the world!

But It Ain’t Perfect
Figure C
If we extend the term of the risk free and risky bonds to 2 years, assuming an annual payment, then the risky bond will be priced according to Figure C. Using this methodology, the risky bond is valued at $983,177, and the risk free bond is valued at $1,000,458. This is a difference of $17,280.

Figure D
Running our Credit Default Swap pricing (Figure D), we come up with a slightly different value of $17,486, for a difference of $206 versus our Bond Pricing methodology. This difference is attributable to a couple of different factors. If there is a default in time 1, then there will be no interest payment nor recovery of it in time 2, whereas for the risk-free bond this would not occur. If there is a default in time 2, we have already earned the time 1 interest payment on both sets of bonds, while the Credit Default Pricing deals only with one set amount which does not vary from period to period.
The valuation difference is a little over 1% of the total value, so there is still a fairly good tracking of the Credit Default Swap pricing versus the Bond Pricing, but there is a difference. In hedging terminology, the fact that there is some fundamental difference between the hedge instrument pricing and the pricing of the item being hedged is called “basis risk”.
Figure E
Let’s see what happens if the curve flattens. If we increase the year 1 probability of default to 5% (thereby inverting the probability of default curve) from 1%, the Credit Default Swap pricing jumps from $17,486 to $41,717 (see Figure E). The Bond Pricing for the risky bond is now $959,770, which creates a difference to the risk-free bond of $40,688. The difference between the two methods is now 2.5% of the Bond Pricing valuation, up from 1% previously. Thus, because of the basis risk the hedge can become less effective as things change through time.

Slight Imperfections Can Add Up!
JP Morgan described the hedge they established as a “macroeconmic hedge”, which would suggest that we can interpret it as follows – “we have investments in some bonds, and in general these things will lose value if the default curve flattens, so we will use CDS index to hedge this, but there is an element of basis risk in the hedge”.
Matt Levine suggested that JPMorgan had up to $1 Trillion in corporate loan exposure. If this were hedged using just our simple example worked out above, the movement of the basis risk between 1% to 2.5% would create a $15 Billion shift in value. So maybe they should be happy if the losses are only $3 Billion!

The Moral of the Story
My purpose in this series of posts was to explore the pricing mechanics of Credit Default Swaps and how they might be used to hedge a debt security investment, and to determine whether a sensational story can be made out of a seemingly prudent undertaking. It seems that it can.

This is not meant to expunge JPMorgan from any wrongdoing. There are a lot of other factors that have been reported about JPMorgan’s hedge which can contribute to the loss other than what we have explored to this point, and not being privy to the gory details leaves me in a position where I cannot fairly judge.
However, we have seen that a simple element such as basis risk can have a large impact on the bottom line if we are dealing in large numbers, and it is therefore important to consider. Many of the spectacular blow-ups in the past, such as Long-Term Capital Management, have basis risk as part of the underlying story as to why they occurred.
For this reason, risk management is something that needs to be executed with an understanding of what may or may not occur under a number of different scenarios. When markets are moving fast, it may be too late to correct for changes in the basis risk inherent in your risk management program.

Key Takeaways
Risk Management is not a precise and exact science. There are often differences between what a business needs to hedge and the securities available to execute it, leading to basis risk. In order to understand potential risks related to the risk management effort, scenario analysis of extreme, sudden, and unexpected market movements should be performed in order to keep our firms from being surprised by the results of our risk management efforts.
Questions
·         Do you think JPMorgan’s losses were the result of speculation or the realities of imperfect hedging solutions?

Add to the discussion with your thoughts, comments, questions and feedback! Please share Treasury Café with others. Thank you!

Friday, June 1, 2012

Into the Belly of the Whale: Curve Balls

In our last post, “Into the Belly of the Whale: Hedging and Credit Default Swaps”, we explored what makes a hedge a hedge and then looked at how the ever-so-mysterious Credit Default Swap is priced.
We now take this knowledge and continue exploring the JP Morgan loss of $2 Billion by their illustrious trader nicknamed “The London Whale”.

What is a “Curve”?
According to Matt Levine and Lisa Pollack, the JPMorgan trade in question was a “curve trade”. While one might think this involves driving a car on mountainous roads, in the world of finance the term “curve” is used differently.
If you put yourself in the shoes of a borrower, you are faced with a choice of when you would like to pay back the money you borrowed. Do we want to issue 5-year debt, 10-year, or 30-year? Homeowners face this same question when they are considering their mortgage.
Figure A
One of the important factors we consider when evaluating this decision is what the interest rate is going to be, because interest rates will be different depending on when the debt is due. We might be able to issue bonds with a rate of 4% if they are due in 5 years, 4.5% if due in 10, 5% if due in 20, and 5.5% if due in 30.
The length of time until the debt is due is called the “term” of the debt. Figure A plots these rates out by their term (I added a few extra for completeness). This picture, and the concept of different rates for different terms of debt, is called the “yield curve”.
Figure B
The yield curve will vary over the course of time. Generically, there are three basic types of yield curve  - upward sloping, flat, and inverted. These are shown in Figure B.
For Credit Default Swaps, the curve concept is the same, but instead of interest rates the points on the graph represent the Credit Default Swap Spread (for example, the 102 basis points we calculated in our last post for a 2-year CDS).
Because the shape of a curve can change over the course of time, it is possible to buy and sell securities that will make or lose money should this occur. According to Matt Levine and Lisa Pollack, part of the JPMorgan hedge in question was a “curve flattener”. This means the transactions were set up to pay-off if the curve became flatter than what it was.

Let’s Pull Up Our Bootstraps
Figure C
Before we think about how curves change, we need to look in particular at one of their properties that become important when thinking about transactions that use them.
Let’s look at a simple probability event like flipping a coin. If the coin is flipped twice, and if heads comes up then there is default, then we know that there is a 50% probability that by the end of period 1 there will be a default and a 75% probability at the end of period 2. This is shown graphically in Figure C.
Figure D
You probably recall from our prior post’s example that the Credit Default Swap price calculation uses a probability of default for each period of time. Given the above information poses a problem for us if we were going to price a CDS with one annual payment. We know from the above that for the first payment the default rate is 50%.
What we are missing is the rate for the second period. Yes, we have a two-year rate of 75%, but that incorporates the first year as well as the second. We want to get the rate for the second year only. The bracket in Figure D shows the time period where the rate we need is missing.
Figure E
Fortunately, since we have 2-year rate and a 1-year rate, we can use the difference between the two to come up with the missing rate, which is 25%. This process is known as bootstrapping. This process is used to establish implied default rates per period for Credit Default Swaps, and is also used extensively in interest rate products (we’ll leave that one for later!). Figure E shows the swap valuation with our Heads and Tails data to prove out the result.
Figure F
Suppose we are faced with a term structure of CDS spreads as shown in Figure F (this curve is from the website onedigit.org). As long as we are willing to “lock down” the loss given default rate, we will be able to work our way through this curve to bootstrap the probabilities.
onedigit.org has been kind enough to provide Visual Basic code so we do not have to go through this process in a tedious, step by step manner.
Figure G
Figure G shows the cumulative probability for the CDS spreads given the discount rate function used by onedigit.org and a loss given default rate of 60%. It also shows the per period probability.
Figure H shows our valuation for the 10 term swap. The rate of 35.2 basis points for the swap is the correct one in order to get the valuation of the contingent leg equal to the value of the fixed payment leg.
Figure H

The World is Getting Flatter?
The period probabilities are important because these are the drivers of change in the price of the Credit Default Swap. If the curve is going to flatten, then one of several things are going to occur:  
a)      short-term probabilities increase more than long-term ones,
b)      long-term probabilities decrease more than short-term ones, or
c)      some combination of a and b.
Figure I
This is shown in Figure I.
In order to generate gains when the curve flattens, we need to buy the short-term part of the curve and sell the long-term. The amount we buy vs. what we sell will be different, because for a change in probabilities of default or the CDS rate the change will be different, since one security is much shorter in length than the other, so there is less to impact.
Figure J
To take an example, say we buy a 2-year CDS and sell the 10-year CDS. To hedge for change in value, it is a ratio of about 4.5 to 1, so Figures J and K show the valuation at the time of our transaction.
Figure K
We now move the probability of default up by 0.1% in every period (a parallel shift). Figures L and M show the valuation of our securities under that scenario. You will notice that our purchase of the short-term gave us a gain of a little over $5,000 and our long-term position has a loss of a little more than $5,000, so we do not make or lose much on a parallel shift.
This is by design, the transaction is supposed to make money when the curve flattens, not when the whole thing shifts up and down.
Figure L
Now we will increase the probability of default by 1% for the first couple of periods only, and leave the other ones alone (not only did the curve flatten, it inverted). Figures N and O show the valuations. Here we made $52,000 on our short-term security and lost $12,000 on the long-term security, for a net gain of $40,000. Not bad for a day’s work!
We will continue on into the belly with our next post.
Figure M

Key Takeaways
The term structure of default rates and interest rates can create different impacts depending on the shape of the curve and how it changes. We can execute derivative transactions that take advantage of this.
Figure N

Questions
·         In your opinion, was JPMorgan speculating or hedging?

Figure O
Add to the discussion with your thoughts, comments, questions and feedback! Please share Treasury Café with others. Thank you!