OIS Discounting – Part 2: The New Interest Rate Modeling Paradigm

Recent years have seen valuation adjustments take centre stage in the pricing and valuation of OTC derivatives. Costs and benefits arising from credit (CVA), debt (DVA), funding (FVA) and collateral (ColVA) have become critically important in defining the dynamics of OTC markets. The newest - and perhaps most significant - member of the VA family is KVA (capital value adjustment).
2 Dec, 2013

These changes have driven a profound shift in the way all OTC products are valued and risk managed. The result has been an abandonment of the classic derivatives pricing framework based on single interest rate curves and the introduction of a new approach, OIS discounting, that takes into account current interest rate dynamics and market segmentation using a multiple curves.

Dual curve/OIS discounting

The old-style no-arbitrage, single-curve derivatives valuation framework where Euribor was a reasonable proxy for a risk-neutral discount rate has been permanently changed by the credit crisis. An understanding of the credit risk embedded in Euribor and similar rates and an increased importance in the modelling of funding have driven a separation between the index rates used for the floating legs of the swap (the projection rates) and the appropriate rates used for present value (the discount rates). The market-standard rate to discount future cash flows is now OIS rates.

The method of projecting rates using Euribor and discounting rates using Eonia changes the fundamental framework for existing derivative modelling. It has required a rethink from first principles that continues to be discussed and refined. Pricing and risk managing even a vanilla single currency swap has become significantly more complex. Curve construction, pricing, and hedging now involve multiple instruments and additional basis risks. These complexities compound for interest rate products such as cross currency swaps, Caps/Floors, and Swaptions.

Funding cost

The debate about appropriate discount rates is still in progress. The role of funding and funding costs is a complex one. The impact of different market participants funding costs, the uncertainty in some institutions about measuring funding costs, and the impact of LVA are the subject of current academic and market debate.

Counterparty risk and CVA

A broader and evolving understanding of valuing and managing Counterparty Credit Risk was well underway before the credit crisis. Many of the larger global banks had been actively measuring and managing counterparty credit risk many years prior to the crisis. The crisis, however, dramatically increased the focus for market participants as well as regulators and accelerated the impact on the broader OTC markets. The measurement and management of counterparty risk is now something that impacts all market participants. Accurate valuation of OTC products now requires accurate valuation of the credit component of each transaction. In addition, regulatory initiatives such as Basel III and Solvency II, along with account rules such as ASC 820 (FAS 157) and IAS 39 have mandated more accurate counterparty risk valuation and risk management.

The larger banks have led the evolution of valuing and managing counterparty credit risk. Over time they have converged to generally consistent methods and processes. The concept of a Credit Value Adjustment (CVA) is now widely accepted and consistently calculated across the markets. OTC transactions that carry counterparty exposure executed by all the larger institutions now have a CVA component as part of the valuation. An accurate CVA calculation takes into account all transactions in the portfolio with that counterparty as well as any netting agreements, CSAs and collateral.

Part 1

OIS Discounting – Part 1: Interest Rate Modeling

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