The rand overnight deposit swap is a new single-tenor swap agreement introduced in the South African market last year. The floating rate is reset against a compounded average of the South African Future Exchange published overnight call rate.
Historically, the South African market had no official rates. One of the semi-official rates was the 91-day bankers acceptance discount rate published by SAFEX. The swap market developed around this rate. However, the reset introduced mismatches between calendar based agreements, with three-month resets, and the 91-day bankers acceptance-based agreements. Recently calendar-based semi-official rates were introduced by SAFEX. The development of a swap market ensured that corporate treasurers could hedge themselves against the full-term structure by swapping the floating payment stream with a fixed rate annuity.
Many treasuries are funded using call-based instruments. The lack of availability of call-based swaps means there is basis risk in the portfolios. This created the need for a call-based swap agreement allowing corporates to swap their exposure from the overnight to the three-month rate and further points on the curve. RODS is the tool designed to answer that need.
A RODS agreement will swap the risk inherent in the tenor of the agreement, for example three months in a three-month RODS, with overnight call exposure.
In non-volatile market conditions the basis risk corporate treasuries are exposed to might not be so pressing. However, the nature of the interest rate market in 1998 means that gaps between the overnight call rate and the longer-term points along the yield curve were volatile and accentuated the need to cater for basis risk. Another local factor that makes RODS an attractive product is the uncertainty associated with being an emerging market. The short-term rate can be used as a tool to manage the economy in times of uncertainty and many corporates do not want to be exposed to political risk.
Tenors of RODS can be up to one year. The floating leg is calculated as the average of the SAFEX call rate at the end of each calendar month. These average rates are compounded, and at the end of the agreement compared with the fixed leg.
The illustration above shows a RODS entered for three months, around the middle of a calendar month. There are four resets in the lifetime of the instrument. At every reset point the average of the SAFEX call rate for the preceding period is calculated. The initial amount is compounded on each of these resets using the average rate of the preceding period.
At the end of the period of the agreement four rates are available. The reset interest for the whole period is calculated as:
More generally for N months RODS the yield for the period is calculated as:
Putting some number into the equations: assume a three-month RODS begins on the 15th of the month. As per the diagram there would be 4 resets. If the average rates at the four resets where: r1=18.00, r 2=17.60, r 2=17.30, and r 2=17.00, then the yield for the period would be:
This is equal to 17.74%. If the fixed rate was 18% then on a 1M nominal a payment of: 1M*(18.00%-17.74%)*91/365 = R648.22 would be due.
The next step is the introduction of RODS-based optionality. RODS-based options are more complex than simple options on quoted rates. The reasons for the complexity are inherent in the reset process. The combination of averaging and compounding means that none of the standard option pricing models apply. As the value of the final rate is dependent upon the daily call rate for the period of the agreement, the value of RODS is path dependent. Therefore specialized tools need to be developed.
Caps and floors are popular in the South African corporate market and RODS-based caps and floors are expected to occupy a large share of the market. The volume of trading in RODS is predicted to be similar to the volume in the forward rate agreement market in one year's time. This will position the weekly turnover at roughly ZAR10 billion (USD1.4 billion) from current volumes of roughly ZAR1 billion.
This week's Learning Curve was written by Arik Shimansky, a Risk Analyst at Decillon, a Johannesburg-based financial and risk management services company.
