Carry and Roll-Down: back to the basics

Interest Rate Traders and salespeople talk about carry and roll-down all the time. It is useful to remember what they are talking about.

1. Upfront Carry:
1. For a 10-year receive fixed swap, the 1 year carry is the net present value of a 10-year swap less the net present value of a 9-year swap starting 1 year from now.
2. Upfront roll-down:
1. For a 10-year receive fixed swap, the 1 year roll-down is the net present value of a 10-year swap and less net present value of a 9-year swap today.
2. Typical documentation will have carry and roll-down for various swap lengths: 1M, 2M, 3M and so on. So a 1 year carry can be provided as 0.45 $ per 100 $ of notional or some other dollar convention.
3. Running Carry:
1. the Upfront Carry divided by the PV01 of the forward starting 9-year swap.
4. Running roll-down:
1. the Upfront roll-down divided by the 9-year swap starting today.
5. Actual Vol-adjusted Running Carry & Running Roll-down:
1. 1Y Running Carry divided by the actual volatility of the 1Y rate over the past 1 year.

How to Read the Quotes:

6. Notional Neutral Switch:
1. Typically quoted as where one receives fixed for the shorter rate and pays fixed for the longer rate.
2. If the expected carry and roll-down is 180bps on a 5s/30s – one should read this as follows. For an investor, who receives fixed on a 5 year swap 1mn notional and pays fixed on a 30 year swap 1mn notional -- expected profit is 180,000.
7. Duration Neutral Switch:
1. Typically quoted where one receives a short dated swap, and pays a long dated swap.
2. The notionals can vary here – such that the durations cancel out.
8. Butterfly:
1. Quoted as 2bps on a 3s/4s/15s. Read this as expected roll-down and carry as pay fixed on the 3yr and the 15yr, and receive the 4yr fixed rate.
   

CDS on Sri Lanka!!

Last week, Sri Lanka issued its first international bond for $500 million. Predictably, a CDS market has evolved – with the 5 yr CDS trading at 360 b.p. I am not sure if there has been any study that decomposes this spread into: (a) Sri Lanka’s abilities to repay given increased hikes in domestic rates and decline in economic growth locally (b) sustained international risk-appetite? Theoretically, CDS is equivalent to a bond financed with an hedge on it -- thus making it an unfunded deal (can you see that?). Thus, CDS premium is compared to a asset swap -- and not to a bond's spread on the treasuries. More loosely, in cases like Sri Lanka where an asset swap market are not known to trade actively, CDS premiums tend to lead Bond premiums – and given the highly volatile political and economic climate – there can be substantial divergence in the intermediate term spreads quoted in the CDS and the Bond market. Typically, the CDS premia are on average higher over time than the Bond risk-premia. This CDS Basis (i.e., strictly speaking CDS Basis = CDS spreads - Asset Swap Spreads) can fluctuate substantially -- and Sri Lanka should be no different.
Things that make the CDS Basis tighter:

• Other Credit Products launched on Sri Lanka. (Pretty Unlikely)
• Decline in Civil War (Unlikely)
• If Credit Quality improves and Sri Lanka has any reduced coupon clauses. (Unclear)

More thought is required, but if Sri Lanka is met with success -- one could see a rising increasing in issues/CDS from "really small open economies".