Nov 11, 2011

OIS Discounting and OTC Derivatives: Demystifying the Confusion

Market participants are seeking a deeper understanding when it comes to the potential impact of moving to OIS discounting. The recent uptick in OIS curves as the valuation discounting basis for collateralized derivative deals, and the use of dual-curve pricing, has inspired us to more closely examine the use of separate forecasting and discounting curves, in addition to exploring the impact of newly proposed ISDA Standard Credit Support Annex (SCSA) on today’s financial institutions. On November 8th, leading derivative analytics provider Numerix, along with industry expert, Dr. Greg Cripps, President of Prism Valuation, hosted a webinar to help demystify the confusion behind OIS discounting in the OTC marketplace.

The Evolution Toward Separate Forecasting and Discounting Curves

In 2008, the world dramatically changed... It is well-known that prior to the financial crisis, life was simpler with market participants mainly relying on the LIBOR curve to forecast the LIBOR rate and discount the cash flow.  “Today’s market participants realize that we need separate forecasting and discounting curves,” Dr. Cripps explained. “The post-crisis financial world is very different, and the old way is just not going to work anymore,” he said.

When it comes to the current methods for discounting future cashflows, the market is evolving toward OIS discounting of future cashflows assuming two-way collateral agreement without thresholds. “Most believe that the current situation with threshold and multi-currency CSAs is too complex and unsustainable and that a more standardized CSA would be a better approach,” Dr. Cripps added.  

The proposed ISDA SCSA, targeted for 2012, is in line with the ‘’SwapClear model’’, and promotes the following standards: Collateral is posted in major currencies (USD,EUR,GBP,CHF,JPY); Collateral is posted in the ‘’natural’’ currency of any deal exposure; and OIS curve discounting is used to calculate values.

“While things are evolving, some people are still using the old practices, with LIBOR discounting prevailing in many Back Offices,” he said. “But, we are also seeing a new trend emerging with most valuation vendors offering the option to use OIS discounting.”

What is the ‘Curve Generation Recipe?’

“In the new environment, the ‘curve generation recipe’ is to use one curve for discounting and a different  curve for forecasting,” Cripps reiterated.

 

 Potential Impact of Moving from LIBOR to OIS Discounting

 

Examples

  • Swap = USD10MM, 25Y, Rec 5%, Pay 3M Libor
    PV (OIS) = 3,885,938, PV(Libor) =3,781,256,  +104 bps
     
  • Swaption = EUR10MM, 10Y->20Y, RTR = 5%
    PV (OIS) = 1,438,128, PV(Libor) = 1,385,317,  +53 bps
     
  • Zero Swap = USD10MM, 20Y,  Rec 5%, Pay Libor compounded
    PV (OIS) = 4,798,006, PV(Libor) = 4,602,159 , +196 bps
     
  • Inflation Swap = GBP10MM, 40Y, Receive 3.5%, Pay inflation
    PV (OIS) = 499,138, PV(Libor) = 451,912,  +47 bps

 Looking Ahead: Practical Solutions for Today’s OIS Challenges

Looking toward the future, we can see that the valuation of derivatives requires forecasting curves, dependent on an underlying index, in addition to separate discounting curves, dependent on counterparty credit or funding of collateral. The new ISDA SCSA effort will significantly alleviate complexity issues, but many legacy trades will likely need to be managed under their original CSAs. In addition, valuation models will need to be updated for CVA calculations and OIS discounting.

Dr. Thomas Davis, VP of the Client Solutions Group at Numerix, explained the broad capabilities of the Numerix CrossAsset library when it comes to multi-curve pricing and OIS support, such as the ability to price linear instruments with multi curves; bootstrapping OIS (EONIA, SONIA, MUTAN) curves; and the additional OIS functionality that Numerix will introduce in January, including the calibration of stochastic models. So, stay tuned…

If you have further questions, or would like more information about Numerix solutions, please contact sales@numerix.com.

Blog Post - Jun 23, 2011

Improving Risk Management and Transparency for Structured Products

Need Assistance?

Want More From Numerix? Subscribe to our mailing list to stay current on what we're doing and thinking

Want More from Numerix?

Subscribe to our mailing list to stay current on what we're doing and thinking at Numerix

Subscribe Today!