Aug 22, 2012

The Impact of OIS Discounting on the Pricing of Non-Linear Interest Rate Structures

How will the evolution of the interest rate options market toward the OIS approach impact pricing and modeling risks?  As part of our ongoing exploration into the market’s increasing complexities given OIS discounting and multi-curve approaches, we’ll be taking a closer look at what is happening more specifically in the options market today and what we can expect to see more of in the future.

When it comes to the pricing of non-linear interest rate structures - including swaptions, caps and floors and their volatility surfaces - what do we really need to know? The bottom line: When it comes to the mispricing risks resulting from the current market’s evolution, practitioners must be vigilant about potentially big discrepancies in valuations and dealer quote interpretations (i.e. Are the dealer quotes based on the classical, single-curve approach or the modern, multi-curve approach? How can we be clear?)

Essentially, as the swaptions and IR caps/floors markets gravitate toward the OIS approach, market participants will most likely need to re-engineer their pricing libraries to accommodate the changes in quotations.  Given the way the market is changing, it would naturally follow that models and calibration should also incorporate multiple interest rate curves.

The Importance of Understanding Today’s Market Quotations

In the past, market quotations for swaption and cap/floor surfaces were given in terms of implied BS (Black Scholes )-vols under Libor discounting. Today, however, how do we accurately interpret vols, when it is often unclear whether the Libor or OIS discounting approach was applied? Market participants need to understand how the dealer is quoting vols and premiums—otherwise they will face significant valuation risks. Again, we can see why pricing and financial library systems should be carefully reviewed and re-engineered to adopt new market quotations.

Highlights from Webinar Case Study Example

Clearly per the example below (Exhibit 1, 1A, 1B) we can see that if the dealer quotes vols in terms of premiums—and we misinterpret these quotes—we could end up with a significant difference in implied vols under single curve or OIS discounting curve

Exhibit 1: Swaption Premiums to Implied Volatilities

OISAug2chart

Exhibit 1A: Implied Vols (Euribor Discounting)

OIS2Aug2Image

Exhibit 1B: Implied Vols (Eonia Discounting) OIS3ImageAug2

Example: As we can see, if your dealer gives you quotes in terms of swaption premiums, and you would like to convert those to volatilities—you will obtain totally different volatilities under Euribor discounting versus Eonia discounting.

Exhibit 2: Swaptions and Volatility Surfaces: A Graphical Representation

  OISBlogGraphicAug2

The diagram above highlights the significant difference in implied vols, depending on single curve or OIS discounting curve assumptions.

When we look at the extreme differences in basis points in the graph above?ranging from 5 to over 800 bps?we see that typically the differences increase for longer tenors and maturities, like the longer-dated 30Y. We also note that significant differences would exist for pricing and model calibration. Therefore, it should again be emphasized that market participants must really know and understand the interpretation of the dealer quotes in their models, because it can (and will!) make a significant difference.

To learn more, view the full webinar replay,or contact marketing@numerix.com for more information.

Related Reading:

Blog Post - Jun 23, 2011

Improving Risk Management and Transparency for Structured Products

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