Interest Rate Swap, Cap/ Floor, Cross Currency Swap, Swaption, Inflation Swap, Callable Swap - key risks and features

MiFID II

The above products allow clients to reduce risks and exposures created by movements in interest rates, FX or inflation and are generally linked to financing arrangements such as loans or bonds. These products are generally used to manage cash flow or fair value volatility and reduce risks presented by interest rate or inflation fluctuations.

Key risks and features

  • Market Risk

    • Market risk can materialise for a variety of different reasons and may have a significant impact on valuation of a particular instrument or more broadly on the operation of financial markets as a whole.
    • Hedging instruments are typically used to reduce market risks however there is the potential for clients to realise hedge ineffectiveness or opportunity costs as a result of changing market prices or market operation. For example, with hindsight, it may be that a derivative user may have been better off by leaving an exposure unhedged. 
  • Credit Risk

    • By entering into a bilateral contract a client is taking on a credit risk to Investec Bank plc. In the event that Investec should default onits obligations or become insolvent a client may not receive back the full value of their transactions.
  • Volatility Risk

    • In more volatile market conditions clients may be subject to wider spreads with regards to pricing i.e. with respect to the spread they achieved when entering into a transaction.
    • For transactions which are collateralised, increases in volatility could result in larger or more frequent collateral payments than a client may be used to.
    • Changes in volatility will have an impact on the mark to market of a derivative contract.
  • Liquidity Risk

    • Different interest rate and inflation instruments exhibit different liquidity risks which depend on, inter alia, trade tenor, trade currency, the underlying indices being referenced, trade size and time of day.
    • In markets or products with less liquidity clients may be subject to a wider spread with regards to pricing.
  • FX Risk

    • FX risk and currency basis risk is typically only applicable with regards to the Cross Currency Swap valuation albeit there can be occasions where the currency of collateral being posted under any collateralised trading line will impact trade valuation.
    • Currency swap valuation requires observation of several market parameters and given that these trades often involve long-term exchange of notional amounts in different currencies, these trades can carry significant market and credit risks.
  • Concentration Risk

    • Concentration risk is not applicable to these products.
  • Conflicts Risk

    • Investec may take and /or hold positions that conflict with those of our clients.
    • Conflicts arising from Investec’s business model, such as the one noted above, are managed through internal controls and process and is detailed in the Conflicts of Interest policy which can be found on the website.
  • Transparency

    • In most major currencies, Interest Rate markets are relatively transparent with live market pricing available via various sources and advisors.
    • Where markets are less transparent, for example with infrequently traded inflation indices, it can be challenging to form an assessment of a contract’s fair value.  
  • Margin Risk

    • Investec may, from time to time, request that a client posts collateral against a trading position, subject to the specific arrangements agreed between Investec and client. These funds are required in order to protect Investec from losses should a client default on their obligations or become insolvent.
    • Collateral held for MiFID Professional clients will be held in a margin account under a Title Transfer Collateral Arrangement (“TTCA”). A TTCA is a legal arrangement that gives Investec ownership of the client's margin funds whilst they are in possession of the Bank. Investec can therefore utilise these funds as required for liquidity or investment purposes as is deemed necessary.
    • A client that has funds held by Investec as collateral  is also exposed to the credit risk outlined above.
  • Contingent Liabilities

    • Derivative products can carry contingent liabilities. For example, with finance-linked transactions, it may be that a client is legally required to terminate hedges ahead of scheduled maturity.
  • Exit Costs

    • These products rarely have explicit exit fees that are payable above and beyond a client’s contractual close-out price/obligations should they wish to close a position early, however there may be costs involved in this process depending upon market conditions at the time the client wishes to exit. A client may not be able to redeem full original value of the contract.
    • A client's ability to exit early will also be dependent upon the liquidity of the market at the time, should a market be illiquid at the point of early exit then the exit costs are likely to be more significant.
    • Where hedges mature in line with their original contract term, then no additional hedge related costs are typically payable provided the client satisfies their contractual obligations.
  • Leverage

    • Net sold optionality creates a gearing effect on both risks and returns.
  • Interest Rate Risk

    • All products listed above are exposed to an element of interest rate risk as future expected cash flows are typically discounted at relevant prevailing market interest rates in order to ascertain the fair value of the instrument. Where instruments are used to reduce exposure to interest rates, be that floating interest rates payable under a loan, or the fair value of debt obligations issued in form of a fixed rate bond given that these trades are often long term in nature they can carry significant market and credit risks.