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Overhaul of Interest Rate Modelling

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A new generation of interest rate modelling is evolving, as an approach based on overnight indexed swap discounting and integrated credit valuation adjustment is becoming the market consensus.

There is compelling evidence that the market for interest rate products has moved to pricing on this basis, but not all market participants are at the stage where existing legacy valuation and risk legacy valuations are up to date. The changes required for existing systems are significant and present many challenges in an environment where efficient use of capital at the business line level is becoming increasingly important.

Prior to the credit crisis, interest rate modelling was generally well understood. 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. Today, a new interest rate modelling framework is evolving. 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 OIS discounting. In addition, the counterparty credit risk of (uncollateralized) OTC transactions is measured as a CVA.

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