A Day in the Life of a…Derivative TraderA Day in the Life of a…Derivative Trader

Joe Tessmer, CFAJoe Tessmer, CFA

March 11, 2011March 11, 2011

Agenda 8:00-8:30 – Introductions 8:30-9:30 – Day in the Life of… 9:30-9:40 – Break 9:40-10:30 – Current Derivative Topics 10:30-11:00 – Q&A

Introductions Company / College Current position / Major Three Questions

• Experience with derivatives?

• What would you like to get out of today?

• Current topic of interest?

Education Graduated from Roseville Area High School in

2000 Graduated from Boston University

Undergraduate School of Management in 2004 (Finance/Accounting)

Received CFA charter October 2008 Recently engaged with plan for a 2012

wedding

Internships Summer 2001: Fairview-University Medical

Center• Finance Analyst

Summer 2002: Classic Design Services• Accounting / Finance projects

Summer 2003: Neuberger Berman• Financial Analyst in Corporate Finance Group

Career Path July 2004-July 2005: Classic Design Services

• Financial Analyst / Accounting Manager August 2005-January 2006: US Bank

• Derivative confirmations• Contract employee for first three months

January 2006-August 2006: US Bank• Analyst on Municipal Tender Option Bond

program August 2006-Today: US Bank

• Derivative/Funding desk

About US Bank 5th largest bank in the country – $308B in assets Relatively light user of derivatives

US Bank - Treasury Department Department Structure

• Derivatives & Funding

• Investment Portfolio

• Asset/Liability Management

• Economic Capital / Quantitative

• Capital / Liquidity

• Bank Support / Securitization / Equity Investments

• Money Center (Fixed Income Sales)

• Treasury Operations

• Treasury Systems

Derivatives & Funding Desk Head of Derivatives & Funding 5 Traders

• 2 Derivatives & Term Funding Traders (Joe)

• 2 Overnight Funding Traders

• 1 “Swing Trader”: Derivatives, Term Funding, & Backup Overnight Trader

1 Middle Office Analyst (reports to Joe)

Derivatives & Funding Trader Derivatives

• Customer trades & related hedging• Balance sheet hedging

Term Funding• USB internal cost of funds• Bank notes / Medium term notes / FHLB

Advances• Capital transactions

– Hybrid capital / Preferred stock

Share Repurchase Program

US Bank – Provider & End User of Derivatives Customer Activity

• Interest Rate Derivatives• Foreign Exchange

Balance Sheet Hedging• Interest Rate Derivatives• Foreign Exchange• Credit Derivatives• Equity Derivatives• Funding Transactions with Embedded

Derivatives

Typical Day 7:00-8:30: News/Economic releases/Email 8:30-End of day: Derivative trades/Funding

transactions/Reporting/Projects/? Generally leave office between 6-6:30 pm

Typical Daily Activities

Talk on the phone Keep up on email

• Receive 500+ emails per day; mostly market commentary

Meetings/Conferences Calls• Internal: Projects; Monthly meetings• External: Investment bankers

Customer Derivative Trades Monitor rates & equity markets Lunch at desk Instant messaging Watch TV

Systems, Tools & Information Resources Derivative Valuation Model Bloomberg Reuters SNL Financial Calculator (TI BAII Plus) Internal Operations System Investment Banks

• Sales people

• Websites

Types of Customer Derivatives Interest Rate Swaps Caps/Floors/Collars Swaptions Treasury Locks Risk Participations

London Interbank Offer Rate (LIBOR) Indicative rate of where banks can borrow

USD for various terms in the London interbank market

Currently a survey of 16 banks (soon to be 20)• Drop high and low quartile• Average middle 8 submissions

Used as the floating index on swaps and mortgages

Primary inputs for deriving swap curve Not based on actual trades

Interest Rate Swap

Customer Interest Rate Swap

Customer takes out floating rate loan with U.S. Bank Customer wants to hedge against rising interest rates U.S. Bank enters into a “receive fix” swap with customer U.S. Bank simultaneously enters into “pay fix” swap w/ street

Final outcome: U.S. Bank is hedged and has made 25 bps Customer has a locked in fixed rate at 7% (5% + 2%)

Swap Counterparty

Customer

Credit Default Swap Protection against default of a reference entity Buyer of protection makes periodic payments Seller of protection agrees to make buyer

whole if the reference entity has a “Credit Event”

Credit Event• Bankruptcy

• Failure to Pay

Total Return Swap Buyer receives the total return of an underlying

instrument (i.e. equity indices, individual stocks)

Buyer pays Libor +/- Spread Synthetic way of going long/short a security More efficient way of hedging equity-based

risk• USB uses to hedge deferred compensation

program

Wall Street Counterparties Bank of America Bank of Montreal Barclays BNP Paribas Citigroup Credit Suisse Deutsche Bank Goldman Sachs

HSBC JP Morgan Morgan Stanley Royal Bank of Canada Royal Bank of Scotland UBS Wells Fargo

Derivative Position Skill Set Bond math Knowledge of fixed income markets Keep up on current events Working knowledge of accounting Interpersonal skills

Finding a Position in Derivatives Understand finance basics

• Present value concepts

Understand bond math Conversational knowledge of different types of

derivatives Look for related positions

• Middle office, back office

Emphasize ability to learn new things

Q & A Questions?

1 am, Monday, September 15, 2008 What happened?

September 15, 2008 Just before 1 am, Lehman Brothers files for

bankruptcy• Largest bankruptcy filing in US history

• $639 billion in assets

Lehman Bankruptcy - The Morning After Scenario

• Your firm has 72 trades with Lehman’s derivative unit, Lehman Brothers Special Financing (LBSF)

• 6 am Monday Morning– What do you do now?

Default Notice

Lehman Brothers Holdings bankruptcy triggers event of default under ISDA

USB’s counsel hand delivers a default notice to Lehman’s headquarters on September 16• Default notice effectively terminates all

transactions with LBSF

Next Step Are we done with our Lehman trades?

Replacement Hedges – Market Quotation Under the terms of the ISDA, Early

Termination values are determined by a Market Quotation procedure• At least 3 market-makers need to value trades

simultaneously

• 72 trades * 3 Market-makers = 216 trade indications

Replacement Trades 13 Hedging Swaps 36 Libor Customer Swaps 21 Non-standard Customer Swaps 2 Loan Credit Default Swaps 1 Cross Currency Swap

What do we hedge first?

Replacement Trades Combine market quotation with bid process Majority of Lehman counterparties following

same process Some dealers don’t trade certain swaps

• SIFMA (Municipal index)

• Prime

• Commercial Paper

• Libor Averaging

Lehman Post Mortem Trade execution completed Wednesday,

September 17 (3 days start to finish) Loss of hedge accounting treatment Bankruptcy resulted in derivative losses of

12MM for USB Lehman bankruptcy claims trading around

$0.40/dollar in secondary market What can we do to make sure this does not

happen again?

Dodd-Frank Financial Reform Bill Combination of Lehman and AIG lead to

additional regulation of OTC derivative market Title VI – Volcker Rule Title VII – Derivative Reform

• New regulators– Swaps: CFTC

– Security-based swaps: SEC

Title VI - Volcker Rule Prohibits an insured depository institution

from:• Engaging in “proprietary trading”

• Acquiring or retaining an interest in a hedge fund or private equity fund

How do we define proprietary trading?

Title VII - Derivative Reform Market participants that meet specific criteria

will be classified as swap dealers or major swap participants• Must register with CFTC (swaps) or SEC

(security-based swaps)

Trades must be cleared through a Central Counterparty Clearing House (CCP)

End users exempted from clearing requirement

Swap Execution Facility If the product is offered on a platform, a trade

must be executed on a Swap Execution Facility (SEF)

Request for Quote vs. Central Order Book Over the phone trading not allowed for SEF

eligible trades• Block trade exemption

Additional capital and margin requirements for non-cleared trades

Central Clearing Model Current Model

• USB calls swap dealer and executes over the phone

• All payments sent between USB and dealer

Central Clearing Model• USB executes trade through SEF with swap

dealer

• CCP steps in between to become the counterparty to both parties of the trade

• All payments run through CCP

Real Time Reporting & Record Keeping All trades must be reported to a Swap Data

Repository (SDR) as soon as technologically practicable

Delayed reporting for block trades Mandated electronic confirmations Complete records must be kept for 5 years

after maturity

Title VII - Derivative Reform All rules must be released by July 2011 (1

year after Dodd-Frank signed into law) Current law says that implementation must be

completed by September 2011 Most likely scenario has implementation

required in stages over the next 12-18 months

Q & A Additional questions?