Spain: Interest rate derivatives

A EUROMONEY SURVEY - MARCH 1996

INTRODUCTION

Spanish capital markets today can be characterized by rapid internationalization. This is illustrated in the interest rate markets by the growing predominance of Libor (London interbank offer rate) references over the domestic Mibor (Madrid interbank offer rate) references. However, local market characteristics remain strong.

In 1995, Spanish corporates and investors faced a high level of uncertainty both politically and economically, with strong volatilities in interest rates and the peseta. Managing these risks has become a major concern and the use of second-generation products is increasingly common. The most frequently-used risk management strategies are detailed in this chapter, with a distinction between the instruments geared toward borrowers and those meant for investors. All examples are illustrated with indicative prices (quoted on 29/1/96) against six-month Mibor.

GLOBAL MARKET OVERVIEW

Interest rate FRAs

Although today the market for long-term products has become more important, at one time forward rate agreements (FRAs) were the most popular hedging instrument among corporates. There is a market for three-month, six-month and one-year FRAs based on IMM dates, known as FRAs fijos - similar to the MEFF futures contracts on three-month and 12-month Mibor. These last two contracts are less actively traded than, for example, the MEFF contract on long-term rates. The FRA market is preferred when trading larger amounts, whereas for smaller amounts the bid-offer spread is tighter on the exchange.

Interest rate swaps

There are two markets in the local currency: the Euromarket for swaps against Libor and the domestic market for swaps against Mibor. The characteristics of these markets are compared in the table below.

Although Spanish corporates and banks mainly use the domestic market, it remains substantially less liquid than the Euromarket. In the absence of reliable statistics on the total volumes traded in both markets, it is estimated that the Euromarket is several times larger than the domestic market. This is reflected in the average deal size on the interbank market: in swaps against Mibor market size starts at Pta1 billion; for swaps against Libor, anything under Pta3 billion is considered a small amount. The bid-offer spread is also consistently narrower in the Euromarket: six basis points compared to eight basis points in the domestic market today. In the latter market, 10 basis points was a common quote during most of 1995.

The depth of the Euromarket is especially relevant for longer maturities. Whereas most of the activity in swaps against Mibor takes place in the two-year to five-year segment, swapped bond issues and asset swaps have fostered an active market for long swaps against Libor. It is possible to find 12-year prices and, when the market is not too volatile, 15-year prices. At the longer end, the Spanish yield curve is not as steep as that of other European currencies. This is accounted for by the relative scarcity of the 15-year government bond benchmark, actively sought-after by Spanish insurance companies and other long-term investors. Its yield-to-maturity is thus kept close to that of the 10-year government bond. However, recurring interest in paying the fixed rate in asset swaps has put pressure on the 15-year swap offer and has kept it from converging toward the 10-year swap rate in the same way.

Even when converted on the same basis, there is a difference between Euromarket and domestic swap rates in peseta. Depending on the maturity, swaps against Libor are 10-15 bp higher than swaps against Mibor (see chart on p.21). Several factors explain this difference. For instance, the cash-rich swap market players, notably the Spanish savings banks, deal mostly in the interbank market, while the London-based market-makers in the Euromarket are typically short of cash in pesetas. Another explanation for this difference is two-fold :

* the so-called Mibor, as defined by the Bank of Spain, is in fact a middle rate and not an offered rate like Libor, accounting for a difference equal to half the bid-offer spread in the peseta money market;

* the remaining difference between Mibor and Libor swap rates can be regarded as a risk premium during periods of currency crisis when there is specific pressure on Libor, as non-residents borrow the peseta to sell it short.

In previous years, the difference between Euromarket and domestic swap rates has been quite volatile, sometimes even negative (ie, Mibor swap rates higher than Libor swap rates).

The spread between (Libor) swap rates and government bond yields fluctuated last year between 5bp and 20bp, never dropping below zero (ie, bond yields higher than swap rates) as was the case in previous years and in other currencies such as the lira. In early September, this spread dipped briefly under five, giving rise to a flurry of asset swap activity.

Interest rate options

The caps and floors market is similar to the interest rate swap market in that it can be subdivided into options against Mibor and options against Libor, the latter being more liquid, with a higher average deal size and a more active market for longer maturities. This is even more true of swaptions, where the interbank market has so far been dominated by non-resident banks, making Libor the main underlying reference. As Spanish banks plan to become more active in the market, this may change.

REVIEW OF THE YEAR

After the currency crisis resulted in the March 1995 devaluation, short-term volatility dropped steadily in 1995 (see chart below left).

Market-makers realized that implied volatility, at around 18% to 20%, was far higher than the current historic volatility of 10% to 11%. Even in the height of the currency crisis, interest rates were never used aggressively to support the peseta. A senior official at the ministry of finance claimed that this strategy was not being considered, as previous crises had shown it to be pointless. As for the Bank of Spain, the decision to raise rates was said to be a result of inflationary concerns, not foreign exchange considerations. After a major devaluation and with no sign of the economy overheating, the probability of dramatic interest rate tensions in the near future was low.
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