Dec 5, 2012

Using Cheapest-To-Deliver (CTD) Collateral for Accurate OTC Derivatives Valuation

In this video blog, James Jockle, SVP of Marketing, and Anna Barbashova, Business Analyst in the Client Solutions Group explore the embedded optionality of multi-currency CSAs and the challenges banks face in terms of collateral management and optimization. Anna identifies why CTD (Cheapest-to-Deliver) collateral is necessary, why cheapest isn’t always optimal and the benefits a CTD solution can bring to the otc derivative valuation process.

Weigh in and continue the conversation on Twitter @nxanalytics, LinkedIn, or in the comments section below.


Blog Transcript: Using Cheapest-To-Deliver (CTD) Collateral for Accurate OTC Derivative Valuation

Jockle (Host): Hi Welcome to Numerix Video Blog I’m Jim Jockle. With me today is Anna Barbashova from the client solutions group. How you doing Anna?

Barbashova (Guest): Hi Jim.

Jockle: A lot of people might know Anna by voice only and by papers from the Numerix webinar series we’ve been conducting on the past few months on OIS discounting. It’s great to have you on video today thank you for your time.

Collateral shortfall and collateral management clearly in the news more important now than it has ever been especially as we think of the announcements this week that some of the dealers are going to be moving to a standard CSA. However, there’s so much optionality in existing CSAs that are going to be on the books for many, many years. Why is the importance of managing cheapest to deliver and building these curves as part of the valuation process why is that so important at this point and time.

Barbashova: Well as you said, there’s a lot of optionality embedded in the current CSA agreements where they allow collateral to put in cash or Treasury bond or corporate bonds in various currencies. And therefore it’s really important for the bank or the firm to identify which one will be the cheapest one to post because by minimizing the funding rates that they are earning on collateral they will maximize their return and it will come back to their front office books. So of course the most important thing is profit.

Jockle: So essentially it is changing the way valuations are done. It’s not just a pre-trade discovery of what is the cheapest to deliver over time it’s almost intrinsic to the valuation process in something that is recalculated daily. Is that correct?

Barbashova: Well yeah, you will have almost unique CSA agreements for each of the trades therefore you will need to identify the cheapest collateral possible for each of those trades everyday over time because you need to figure out through the time if you need to switch that collateral if the cheapest will be a different one.

Jockle: So I know we talked a lot about OIS discounting and the complexity and thinking in terms of building the CTD curves themselves how complex is even the most simplistic OTC valuation.

Barbashova: Well we all know before the crisis we had just one LIBOR curve, and we’d use it for projection and discounting but with the divergence of the rate between the LIBOR and OIS we needed to use the OIS curve right now for discounting. Let’s take a simple example. You have a CSA agreement that allows you to post collateral in cash in three different currencies that means you need to build the curves for each of those currencies the OIS that you need to build the projection curves, the cross currency curves, ect. ect. and you end up around 15 curves to build for just the three currencies for cash collateral.
Jockle: So the complexity is almost overwhelming in terms of the management. But let me ask you one question you said this in your webinar that we were talking about the other day cheapest to deliver isn’t always optimal. Can you talk about that a little bit in terms of collateral management?

Barbashova: Well you need to look at cheapest to deliver and optimizing what assets you have in your firm and how you want them to allocate to different trades. Say for example you compute your cheapest to deliver curve and you identify which one will be the cheapest collateral to post but what if you don’t have it in your pool of assets that means you have to go outside and source it or go and get it somehow but what if it’s more expensive than taking the next cheapest to deliver collateral that you have in your assets and post that one instead. So saying that it’s really important for the firm to have the collateral management system that will have the rules and requirements on top of determining which one is the cheapest to deliver as well.

Jockle: Well Anna, thank you for demystifying some of the issues in the marketplace for those interested slides from Anna’s webinar earlier this week are available upon request. And follow the debate because clearing we’re not done talking about this follow along @nxanalytics on Twitter as well as our blog on Numerix.com. Anna thank you so much.

Barbashova: Thanks very much Jim.

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