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.
- A new generation of interest rate modelling based on dual curve pricing and integrated CVA is evolving
- This new framework requires a rethink of derivative modelling from first principles and presents significant challenges for existing valuation, risk management, and margining system
Following the credit crisis, interest modelling has undergone nothing short of a revolution. During the credit crisis, credit and liquidity issues drove apart previously closely related rates. For example, Euribor basis swap spreads dramatically increased and the spreads between Euribor and Eonia OIS swaps diverged. In addition, the effect of counterparty credit on valuation and risk management dramatically increased. Existing modelling and infrastructure no longer work and a rethink from first principles has taken place.
Today a new interest rate modelling framework is evolving based on overnight index swap (OIS) discounting and integrated credit valuation adjustment (CVA). Pricing a single currency interest rate swap now takes into account the difference between projected rates, such as Euribor that include credit risk, and the rates appropriate for discounting cash flows that are risk free or based on funding cost. This approach is referred to as dual curve, OIS discounting, or CSA discounting and forces a re-derivation of derivatives valuation from first principles. In addition, the counterparty credit risk of OTC transactions are measured as a CVA which takes into account the likelihood that the counterparty will default, along with expected exposures, volatility of these expected exposures, and wrong way risk. In this paper we will focus on OIS discounting as part of this new interest rate modelling framework.