Sep 12, 2012

OIS Discounting - To Clear Or Not To Clear?

Following the 2008 financial crisis, OTC derivative market participants have come to realize 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.

In this video blog, we will delve into this issue with Numerix Host James Jockle, SVP of Marketing, and Satyam Kancharla, VP of Client Solutions, discussing the path to OIS discounting, current challenges, and recent perspectives from Hull and White on the evolving industry debate.

What do you think? Weigh in and continue the conversation at on Twitter @nxanalytics, LinkedIn, or in the comments section below.


Blog Transcript: OIS Discounting – To Clear or Not To Clear

Opening Screen: Numerix Video Blog

Jockle (Host): Hi Welcome to Numerix Video Blog, I’m Jim Jockle with Numerix, and with me today is Satyam Kancharla, Senior Vice President of our Client Solutions Group. Welcome Satyam.

Kancharla (Guest): Hi Jim.

Jockle: To clear or not to clear, that is the question. And not to be too Shakespearian, I think that’s the key question that’s going on in the marketplace. And there’s a lot of complexity in that. I know we only have a few minutes, and we have more than we need to talk about at this point. But I really just kind of want to focus on one of the areas that we’ve covered a lot in our webinars and gotten a lot of client interest in, which has really been around OIS discounting. And just to start you can maybe give us just a little bit of history and background on how we got to where we are today.

Kancharla: The first thing we must realize is that OIS represents a collateralized rate. And the reason this has become a standard is post 2008, we saw a huge increase in the number of collateral agreements and the number of transactions that were guaranteed by daily collateral posting. And as a result, LIBOR was no longer thought to be the right rate for discounting because the amount of money that people raised for funding these derivative transactions is typically raised at a rate that is more closely tied to the OIS rate, because of the collateralized nature of these transactions, than to LIBOR. And that’s the reason why we have shifted to OIS discounting.

Jockle: Let’s start right there. LIBOR, very well established benchmark; OIS, not necessarily the most observable market at this point in time. What kind of challenges are we seeing as a lot of interpolation has to happen just to create these curves?

Kancharla: That is so true. LIBOR has existed for over 20 years now and is the most common benchmark you will see for derivatives transactions. OIS was always something that existed, but it was not as liquid as LIBOR. As 2008 and post 2008 the use of OIS for these transactions, we have seen more instruments that can help to bootstrap OIS curves. But still, there is a shortage of liquidity particularly in the long end, so you can see curves going to 10 years but not much more beyond in most currencies. Also the OIS rate, or “OIS-like” rates, only exist for the major currencies. They do not exist for many of the emerging currencies, and as a result there is a big question as to what curves have to be used for those currencies.

Jockle: Also another question, which we continue to hear about is cross-currency deals. How is that being managed? And I think the biggest question of the day is, what kind of complexity is being entered into in the valuation process that has never been there before.

Kancharla: True, the valuation process truly becomes a very complex activity because of these multiple curves that exist out there. In fact people refer to curve surfaces rather than curves because of the multiple curves including repo curves and so on. What is required to be able to get a handle on these curves accurately, and get a handle on the related volatilities, are really a whole bunch of additional basis swaps and optionality based instruments like options on spreads between OIS and LIBOR or similar, in order to be able to get a handle on these different risk factors – which simply do not exist today. This is the reason why most institutions are now trying to go back to more standardized CSAs, based on what ISDA has recommended and based on what LCH has come up with, in order to eliminate this complexity in the valuation process, in order to eliminate the imbedded optionality in these derivative contracts.

Jockle: I think it’s also important to note, Hull and White have come out and they’re not necessarily in agreement with all of this, in terms of the fundamental issues that are facing quantitative finance. Give us a little insight into that debate.

Kancharla: The big challenge is that some of the changes in methodology that are taking place, and some of the changes that are already being used in banks, break the most basic assumption of modern qualitative finance, which is the risk neutral assumption. And as a result, we see various adjustments, like FVA, DVA, CVA, being applied, and most of these adjustments are actually related to these concepts of collateralization and funding and counterparty risk. And while we have a school of thought that says these assumptions do not actually factor into the pricing, but they’re more cost of doing business and should be handled more at the portfolio level not at the trade level. Where as there is another school of thought that says each and every cost has to be attributed to the trade and managed at the trade level. That’s where the conflict is, and we’ll see where things go. But most of the advanced institutions are already applying these adjustments to the trade rather than just the portfolio.

Jockle: Well I know we have a lot more to talk about. Thank you for your time here today. We will be continuing on this theme, To Clear or Not To Clear and digging further into the consideration of funding. Thank you and have a good afternoon.

Title Screen: Thanks for Joining!

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