July 25, 2013

Did Harvard Never Consider Swaptions? On Larry Summers' Deal That Cost Harvard $1 Billion.

It's the debate of the week! Janet Yellen or Larry Summers as next Fed Chairman?

Yellen over Summers?

Summers over Yellen?

Yellen or Summers?

Sometimes fruitful, sometimes full of hatred, sometimes rhetoric, sometimes thoughtful, the debate has seen people presenting strong cases to prefer one candidate over the other. Does the debate need to hear my opinion? I don't think so. 

As a financial engineer, one specific issue captured my attention as it was brought up by Matthew Klein a few weeks ago: Harvard's long-term swap contracts the school entered in the early 2000s to "hedge" against a rise in interest rates between 2004 and 2008. This post will not discuss responsibilities or take part in the blaming game. Instead, I would like to focus only on the trade itself.

Although we don’t know all the specific details of the deal, we can read Matthew Klein (here), the Epicurean Dealmaker (here) and Brad Delong (here) and have a fair picture of it. 

In the early 2000s, Harvard University was planning to:
  • borrow some money in 2008 for some project/campus expansion;
  • Harvard was concerned about a rise in interest rates between 2004 and 2008;
  • Harvard wanted to hedge the risk of a rise in interest rate between 2004 and 2008;

Therefore, Harvard's Debt Management Committee entered long-term swap contracts in 2004. A decision that later proved to be catastrophic for the school as it lost almost one billion dollars. The swaps were “naked” not “covered”, that is, at that time, Harvard hadn't borrowed the money yet (it was planning to do so in 2008). Without an equivalent and opposite trade, it's hard to see how the swaps could be considered as a hedge against a rise in interest rates. Also, it's hard to see how these contracts could turn automatically into a bet as Harvard cancelled the project in 2007...

Harvard had a better alternative: using swaptions. A swaption (see the picture below) is an option to buy a swap at a future date, at the preset fixed interest rate. For example, a company can buy a 3-month swaption on an underlying 9-month $100 million at 5% fixed interest rate. This gives the company the right to take on a long position in the swap at the end of the third month. The company would make the decision based on the then-prevailing swap rates at the end of the 3-months. Upon exercise, the swap performs just like an ordinary swap. Swaptions can be: payer-swaptions, where the option holder has the right to enter into a pay-fixed swap (i.e. the right to enter into a long position in the swap, therefore hedging a floating interest rate), or receiver-swaptions, where the option holder has the right to enter into a receive-fixed swap (i.e. the right to enter into a short position in the swap).

Swaptions are preferable because:
  • Allow the investor to "wait and see", that is to postpone the decision to enter swap contracts to a later point in time. It also minimizes the costs, as the investor is not committed in any way and it has only the option to enter swaps contracts if and only if the conditions are met;
  • If at expiration (at the end of the third month) conditions are not met, contracts can be rolled over, that is, contracts can be renewed;
  • Allow the investor to focus on the short-term and see how market conditions change. Long-term interest rate swaps are risky (see the intrinsic cash-flow risk). Swaptions give the investor lots of flexibility.

Harvard had a better alternative. Did it never consider it?

The school chose to enter swaps contracts that required a high degree of confidence in the occurrence of specific market conditions. The price the school paid was one billion dollars.


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