Hedging bond portfolios CLS Winter Conference 2014

Historical yields 2

Measures taken to mitigate duration risk 3

Hedges utilising simple derivative strategies 4 Short gilts 6 year bank issued note 1, 2 or 3 times short 7-10 year gilts at maturity Rolling of gilts to maintain duration Additional floating coupon of 3 month libor +…. Short 1 X2 X 3 X 3 M GBP Libor +1.00%2.25% 2.50% Structure implicitly floored if you assume rates can’t go below zero Assuming a gradual increase in yields over the next six years

Fixed rate bonds into floating 5 Collateralised Note Platform Bank Counterparty Investor 1. 3 Month Libor + /- 2. Principal at maturity Cash Collateral Day 1 1.Investor sells existing portfolio of fixed coupon bonds. 2.Investor buys a floating rate note with the cash proceeds. During the life 1.Cash flows arising from the Collateral are passed to the Bank Counterparty. 2.In return, the Bank Counterparty will pay a libor linked coupon. At maturity 1.Investor receives 100 less any default amounts on collateral Fixed Coupons 1. 3 Month Libor + /- Investor effectively creating floating rate notes, whilst maintaining the credit profile of their original portfolio.

Fixed rate bonds into floating 6 Collateral Indicative Coupon Level RBS m GBP Libor + [3.07%] VOD m GBP Libor + [0.59%] CPUK m GBP Libor + [2.34%] LLOYDS m GBP Libor + [7.48%] UKT m GBP Libor +

Hedges utilising simple derivative strategies 7 Are we at maturity of the option? Yes No Are current rates above the option strike level? Yes No Coupon Paid No Coupon Option traded in secondary at MTM Strike (10 year swap rates) Option expiry (years) 3%4%5%6% 32.75%5.00%12.50%N/A 42.50%4.25%9.25%21.00% 52.50%4.00%7.50%16.50% 62.50%3.80%7.00%14.50% 2.5 pence premium buys you Digital Options

Hedges utilising simple derivative strategies 8 Time to maturity (years) Rates Shift 0.00%0.25%0.50% MTM 1.60%1.30%0.50%0.00% Rates Shift 0.50%1.00%2.00%3.00%3.50% MTM 2.80%3.35%5.35%7.75%16.50% Rates Shift1.00%2.00%3.00% MTM4.90%9.45%13.40%7.75%0.00% Digital Option 5 years GBP Strike 6% Coupon 16.5% 2.5% Premium

Hedges utilising simple derivative strategies 9 Payer Swaptions Provides the holder with the right to enter into a fixed versus float swap Party B Party A Pay a fixed rate Receive a float rate At inception the value of the swap is zero, since PV of float leg equal to that of fixed leg. If rates go up, the mark-to-market of the swap will go in favour of Party A and vice versa. Fixed versus float swaps

Hedges utilising simple derivative strategies 10 Are we at maturity of the option? Yes No Are current rates above the option strike level? Yes No Swap value No Payment Option traded in secondary at MTM Payer Swaptions 6 month duration Option to enter into 10 year fixed versus float swap Cash settled, based upon market value of the fixed v float swap at expiry of the option

Hedges utilising simple derivative strategies 11 Payer Swaptions 6 month duration Strike  ATMF + 100bps Swap Expiry (years) Option expiry (years) bps20bps19bps 421bps25bps23bps 5 30bps27bps 6 37bps35bps 1257bps77bps82bps 24105bps135bps167bps

Hedges utilising simple derivative strategies 12 Time to maturity (months) Rates Shift0.00% MTM0.28% 0.20%0.10%0.08%0.04%0.00% Rates Shift0.00% 0.25%0.250%0.50% MTM0.28% 0.33%0.22%0.24%0.12%.02% Rates Shift0.00%0.25%0.50% 1.00% MTM0.28%0.33%0.41%0.24%0.82%0.46% Digital Option 6 months GBP 7 th July 14 – 7 th July 24 fixed v float 35bps premium

Alternative ways to play rates 13 Equity linked digital 6 years GBP S&P / FTSE EKI Put  60% Digital Barrier  60% Coupon Payment  Semi-annual Digital Coupon Both underlyings at or above Digital Barrier 226% * GBP 6-month Libor p.a. Equity linked reverse convertible 10 years GBP S&P / FTSE EKI Put  60% Payment at maturity Both underlyings at or above put barrier 100% + Max (5.80%; 3M Libor +1.30%) Worst of underlying below put barrier 100% + Max (5.80%; 3M Libor +1.30%) minus worst underlying performance

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