Balance Guaranteed Swap

ORE defines the product as follows:

A Balance Guaranteed Swap is similar to an amortizing interest rate swap, but the notional amortization matches actual prepayments of a Reference Security which can be either a tranche or a reference pool of assets, or securitized interest backed by a pool of assets. The BGS differs from an amortizing swap in that the notional amortizations are uncertain.

Source: ORE User Guide, Products catalogue, balanceguaranteedswap.tex.

ORE states the pricing approach as follows:

BGS are priced in ORE using an auxiliary Flexi Swap as a proxy. The amortization schedule of the Flexi Swap is set up as the notional schedule of the BGS assuming a zero CPR (Conditional Prepayment Rate). The lower notional bound of the Flexi Swap is constructed assuming a MaxCPR (Maximum Conditional Prepayment Rate) which is dependent on the Reference Security. The MaxCPR is estimated on the basis of the current CPR, historical CPRs and / or expert judgement as to provide a (hypothetical) sufficiently realistic hedge for the BGS. The option holder in the Flexi Swap is the payer of the structured leg (i.e. the leg replicating the payments of the reference security) in the BGS.

Source: ORE User Guide, Products catalogue, balanceguaranteedswap.tex.

The swap balance pays down like a pool of mortgages. When the underlying loans prepay faster, the notional falls faster. The path is uncertain at trade time. The swap therefore passes the actual prepayments of the security into its own schedule. The balance of the swap stays aligned with the balance of the security.

The BalanceGuaranteedSwapData node is the trade data container for the BalanceGuaranteedSwap trade type. A BGS must have two legs, one fixed and one floating. Each leg typically carries an amortising notional. The node also contains a ReferenceSecurity sub-node. It specifies the Asset Backed Security to which the notional schedule of the BGS is linked. Its value is the prefix ISIN: followed by an ISIN code. The Tranches node describes the tranche notionals of the security. Each tranche is identified by a SecurityId and an optional Description. Each tranche has a Seniority given as a positive integer. Lower values mean higher seniority. The most senior tranche has seniority 1. The tranche notionals sit in a Notionals sub-node.

The product needs a prepayment model because its schedule is uncertain. CPR is the Conditional Prepayment Rate of the reference security. The zero-CPR schedule assumes no prepayment. The MaxCPR path assumes the maximum plausible prepayment. ORE prices the BGS as a Flexi Swap whose notional can move between these two paths. The option holder is the payer of the structured leg. The option value covers the prepayment uncertainty of the security.

• The swap rate levels of the fixed and floating legs.
• The current CPR and the historical CPRs of the security.
• The MaxCPR estimate for the reference security.
• The actual prepayment behaviour of the collateral.
• The discount curve and the spread of the structured leg.
• The tranche structure and the notional schedules.

Fast prepayment shrinks the notional and the remaining exposure. Slow prepayment keeps a larger balance alive for longer.

Each period the security's actual prepayments set the next notional. Realised prepayment replaces the assumption as time passes. Fast prepayment amortises the balance down quickly. The remaining swap exposure shrinks with it. Slow prepayment leaves a larger balance. The optionality between the zero-CPR schedule and the MaxCPR path is consumed as prepayments realise.

A customer that funds or hedges an Asset Backed Security wants the swap balance to follow the collateral. A fixed amortisation schedule cannot match unknown prepayments. The BGS transfers the prepayment uncertainty into the swap. The fixed and floating legs then hedge the security's coupon profile. In ORE Studio a customer books balance guaranteed swaps to value them and run sensitivities on the ORE engine.

ORE's catalogue shows a balance guaranteed swap on a two-tranche security:

<BalanceGuaranteedSwapData>
  <ReferenceSecurity>ISIN:XS0983610930</ReferenceSecurity>
  <Tranches>
    <Tranche>
      <Description>Class A</Description>
      <SecurityId>ISIN:XS0983610930</SecurityId>
      <Seniority>1</Seniority>
      <Notionals>
      ...
      </Notionals>
    </Tranche>
    <Tranche>
      <Description>Class B</Description>
      <SecurityId>ISIN:XS0983610931</SecurityId>
      <Seniority>2</Seniority>
      <Notionals>
      ...
      </Notionals>
    </Tranche>
    <ScheduleData>
    ...
    </ScheduleData>
  </Tranches>
  <LegData>
        <LegType>Fixed</LegType>
         ...
  </LegData>
  <LegData>
        <LegType>Floating</LegType>
         ...
  </LegData>
</BalanceGuaranteedSwapData>

Source: ORE User Guide, Products catalogue, balanceguaranteedswap.tex, listing Balance Guaranteed Swap data. The source listing repeats the opening tag at its end; the closing tag is normalised here.

The auxiliary product used for pricing is the Flexi Swap.