Jul 3, 2013

The Fundamentals of OIS Curve Construction - Where to Start

In this video blog Numerix CMO, Jim Jockle speaks with Olga Us, Senior Quantitative Analyst about her recent PRMIA Master Class lecture, "OIS discounting Valuation Approaches Re-examined." Olga explains the drivers behind this paradigm shift in derivative valuation practices from single curve LIBOR discounting to a dual curve approach.

Olga offers expert insights into key considerations for successful curve construction with OIS – outlining the complex challenges faced and how to manage the process. She concludes with audience reaction to the lecture, addressing the range of questions received.  

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


Video Transcript: The Fundamentals of OIS Curve Construction - Where to Start

Jim Jockle (Host): Hi welcome to Numerix Video Blog, I'm your host Jim Jockle. And with me today, Senior Quantitative Analyst, Olga Us. Welcome Olga, how are you?

Olga Us (Guest): Hello Jim. I'm good thank you. Good to see you.

Jockle: It's good to see you. Thank you so much for joining us today. Recently, Olga hosted an event with PRMIA on a Master Class talking about OIS and curve construction. And in many ways, the LIBOR issues continue to dominate the headlines with the recent transition and takeover by the NYSE of LIBOR. But one of the key challenges that have created issues in the marketplace is the divergence between LIBOR and OIS.
And looking specifically, it's really around the impact of derivatives valuations. So with that curve construction, while arguably maybe not the most sexy part, if you will, of derivatives valuations and trading, has really come to the forefront. So Olga, it would be really helpful for everyone who's listening to really give us a bit of a 101 if you will, on curve construction, and what are some of the key things individuals need to think about as when it comes to curve construction with OIS.

Us:  Right. In the world before the financial crisis, even for the construction of a single currency rate curve we still had to face a few issues. Like which instruments shall we choose between cash, correlated agreement and swaps, at what time quotes should be used for the construction of a particular curve?
Then, what is the interpolation method we want to use to have our curve as smooth as possible.
But now with the introduction of the OIS curve, the picture has changed significantly and now is making one level more complex - but this level is present at every stage at building our market data and valuation. So we have to take into account the multiple curve framework in the construction of almost every market data object. We have to think of it when we build our model and when we build our projected indices for every single asset class.

Jockle: So thinking about this though, where some of it gets even more complex and I think a lot of people have called it dual curve when referring to OIS and LIBOR, is really around the cross currency issues. So perhaps you can give us a little bit of information because I've seen some projections where it's not dual curve – it's nine curves, ten curves, in terms of building it together so can you talk a little bit about that complexity?
Us: Yes. With the rising spreads between the overnight index swap rate and the LIBOR rate. We also see hugely rising spreads between the tenors of the same currency, but the levels of different tenors. And we do have to take into account that we have to have a different curve for example for US dollar three months and US dollar six months.
Because it costs more money for our funding for six months, rather than for three months. And this extends to all tenors of the LIBORs that we might use in obligation. And then moving on from different LIBOR tenors, we have to also take into account the OIS discounting in the construction of our cross currency framework.
So for example for the construction of the two currency model, we considered the domestic currency was the domestic OIS curve and LIBOR rate, and then they need to construct not only the forward LIBOR rate, but also construct the correct OIS discounting curve, for the foreign currency, taking into account that we have to bootstrap which is in the cross currency basis swaps and forward rates.

Jockle: Now as I mentioned at the introduction, you just gave a Master Class presentation to the folks in the PRMIA chapter in London. What were some of the key questions that were coming up from the participants in your lecture?

Us: Well the questions ranged from very basic questions such as how to deal with this curve at all. But then those customers we advised them to contact our sales team – who have Numerix as one of those solutions. And then the more specific questions in dealing with how the calibration works. And what are the inputs and outputs of the calibration. And how do we take into account the orders of protection curve at the level of model and indices and how does it participate in our deal definition. So these kinds questions are found in all levels of valuation curves.

Jockle: Well Olga I want to thank you so much. And for those who want to view Olga's presentations and lectures over at PRMIA London that were earlier in June of this year, they will be available over the summer on video on numerix.com, for on-demand viewing. Olga I want to thank you so much for your time today and sharing your thoughts and insights, and hopefully we'll see you on the Numerix video blog soon.

Us: Thank you Jim. Thank you very much.

Jockle: Thank you.

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