Prior to the credit crisis, interest rate modelling was generally well understood. The underlying fundamental principles had existed for over thirty years with steady evolutions in areas that were most relevant to options and complex products. Credit and liquidity were ignored as their effects were minimal. Pricing a single currency interest rate swap was straightforward. A single interest rate curve was calibrated to liquid market products and future cash flows were estimated and discounted using this single curve. There was little variation between implementations and results across the market were consistent.
Prior to the credit crisis, interest rate modelling was generally well understood. Following the crisis, interest rate modelling has undergone nothing short of a revolution. This whitepaper covers the new generation of interest rate modelling based on overnight index swap (OIS) discounting and integrated Credit Valuation Adjustment (CVA) and how this new framework requires a rethink of derivative modelling from first principles and presents significant challenges for existing valuation, risk management, and margining systems.