Oct 11, 2012

Addressing the LIBOR Debate: The Role of LIBOR in the Valuation of Derivatives

In this video blog, Numerix Host James Jockle, SVP of Marketing, and Satyam Kancharla, SVP of the Client Solutions Group at Numerix, sit down to discuss the changing role of Libor in the valuation of derivatives, along with an overview of some of the new recommendations in the market. Kancharla discusses how Libor is likely to change, new proxies coming to the market, the Martin Wheatley report—and how all of this will impact the complexity of the derivatives valuation process going forward.

What do you think? Weigh in and continue the conversation on Twitter @nxanalytics, LinkedIn, or in the comments section below.

Numerix Video Blog Transcript - Addressing the LIBOR Debate: The Role of LIBOR in the Valuation of Derivatives

Jim Jockle (Host): Hi. Welcome to the Numerix video blog. I’m your host Jim Jockle, and with me today Satyam Kancharla, SVP of the Client Solutions Group at Numerix. Welcome.

Satyam Kancharla (Guest): Hi Jim. Thank you

Jockle: Addressing the Libor debate: Clearly there are lots of headlines going on around this, there are many different recommendations and new proxies coming to market, but really what I want to do today, is focus on the role of Libor in the valuation of derivatives. I think one of the key issues that I know we’ve spoken about as we think about all of these different proposals, are what are the implications going forward when we think about the valuation. So, why don’t you just give us a brief overview of some of these recommendations in the market?

Kancharla: So, the first thing to note, is that Libor has traditionally represented the unsecured lending between banks, which we know is not taking place. But, what is taking place is secured lending, secured by collateral. Which is why OIS has come into prominence, as we’ve discussed in the past. So, what that means is that more and more derivatives are marked as of OIS, and that means from the valuation perspective that OIS becomes a benchmark, and not only do you have to model Libor, which continues to be important, but also the OIS for the discounting.

As for Libor itself, what we’ve seen from the reportthat recently came out, which calls for a new financial conduct authority to replace BBA, is a number of changes in the way Libor is measured and reported. One is, a lot more banks are now going to be involved, or at least requested that they be involved in the Libor-setting process. Secondly, the BBA, or FCA rather, is actually going to drop some currencies. So, we are no longer going to see Libor for the Australian dollar, for example. So that is an interesting question, and we’ll see what happens to all those deals in the market.

Jockle: So, let’s think about that, let’s take the first scenario.  So, more contributors… Libor has been historically at a low fixed rate. If you have more contributors, what are the implications to the Libor numbers themselves?

Kancharla: So one of the possibilities, and this is being discussed in the media, is that if you have more contributors, naturally you are going to attract those that don’t have the same credit ratings as the top 20, or the top 10 banks. What that means is that the Libor from that perspective is going to be higher. And, there is another reason that it is going to be higher, which is that because of the increased oversight on Libor-setting, what we see is that the Libor reported has to be closely tied to actual transactions, which again we know are not many. So, it is likely that the Libor setting will move up. And, the big question is, do we transition to this new set of Libor procedures over time-or, do we make a sudden shift? And, when we make that sudden shift, we could see a jump in that Libor value, which as we know, is used to mark about 350 trillion in currency transactions, and other transactions.

Jockle: So flowing that through to rates, FX, FRAs, where you have that kind of jump, I mean clearly you have OIS discounting coming now, as being driving by LCH as part of the margining, also when looking at the standard CSA, right, we’ve had the diversions between OIS and Libor, and those spreads, and they have pretty much normalized with a couple of hiccups over time, given the market volatility. If you have that kind of jump in Libor itself, how is that going to flow through to the valuations of the instruments?

Kancharla: Well, once the Libor procedures are put in place, and there are time lines that are put in place, what we will likely see is that forwards and long-dated swaps will be marked using the new metrics. And, the market will take a view on how the Libor is likely to change. You will see a forward market that is already moving, as soon as some announcements are being made. And then, once the procedure is put into place, you will actually see the FCA-computed Libor that will come into the picture, and we will no longer have this old Libor. But, the big question is what does that mean for the different people who have loans that are linked to Libor, or swaps that are linked to Libor. You stand to lose or gain, depending on how you are positioned against Libor.

Jockle: So, I think it’s well documented by many market participants that they want to stay with Libor, because of so many contracts, so many legal docs being pegged to Libor, but yet we are seeing other proxies, the dual curve methodology between OIS as well, what is the role of these other proxies that are coming to market?

Kancharla: What I see happening actually, is in the short term, we will see these Libor review steps taking place, but in the long term, I do see as has been outlined in the Martin Wheatley report, that we will see some of these LIBOR alternatives coming into prominence. And, Libor today is used for so many different use cases. The report actually calls for us to review, and for regulators to review the usage of Libor in these different situations and replace them with alternatives, like the OIS obviously, but also short-term debt is a possibility, another is the repo-dependent curve, there is a repo curve that the DTCC has come up with as you know, and also CD and CP rates can be used for benchmarking.

Jockle: So, to sum up very quickly, there is a lot more complexity than what we’ve seen in the past?

Kancharla: Yes, absolutely.

Jockle: OK. Satyam, I know we have a lot more to talk about on this, but I think we’ve hit our time. Thanks for joining our video blog on the Libor debate and valuation of derivatives, I’m Jim Jockle, and we’ll see you next time.

Kancharla: Thank you.

Jockle: Please follow nxanalytics on twitter, as well as check out our regular blog on numerix.com for regular updates. Any ideas and suggestions please feel free to email me or email marketing@numerix.com.

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