Feb 20, 2013

The Buy-Side Impact: Cheapest-to-Deliver Collateral & the Valuation Process

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In this video blog, Numerix experts discuss collateral optimization and the valuation process – specifically exploring why managing CTD collateral and building these curves as part of the valuation process is so important for buy-side participants.

They also address the industry challenges for the buy-side, in terms of collateral analysis and optimization, highlighting the primary market and regulatory drivers. Beyond collateral complexity, they stresses why CTD curve construction and collateral analysis is critical for the buy-side and the benefits CTD curve construction could bring to this side of the market.

Video Transcript: The Buy-Side Impact: Cheapest-to-Deliver Collateral & the Valuation Process

Jim Jockle (Host): Hi welcome to Numerix Video Blog, I’m your host Jim Jockle. Joining me today, Tom Davis, Ph. D. from the Client Solutions Group, greetings Tom, how are you?

Tom Davis (Guest): Good, thanks. Thanks for having me Jim. 

Jockle: How’s the weather in Vancouver?

Davis: Sunny today. First day in months.  

Jockle: Excellent. Sunny all around here on the East Coast as well. Cheapest-to-Deliver and the valuation process, a big question lately around with the buy-side, especially because the given changes in the market, but one of the key questions that keeps coming back is really managing the Cheapest-to-Deliver and building these curves as part of the valuation process, why is this so important?

Davis: Well the buy-side, the core competency on the buy-side is obviously managing portfolios for specific needs such as wealth accumulation or capital preservation.

Now, one thing their core competency isn’t in is complex processes managing collaterals, and they aren’t going to able to scale that up. It is really important especially since 2008 when we saw the move towards multi-curve pricing, that was really driven by collateral requirements, and it’s important to the buy side for two reasons: one is P&L, so how the trade effects the portfolio as well as risk management. If you are over collateralized, if you are not at your optimal collateral level, you can actually get the trade to be turned around and the risk profile is not what you actually think it is, or thought it was, when you put the trade on.

Second of all, in terms in how it fits into your portfolio, if you have a trade that requires a lot of collateral postings daily or weekly, a lot of your transactions will cost you a bit of money, for the instances if you have the outsourced third party vendor solutions for your collateral management, they sometimes trade price per volume in terms of collateral and margin postings, so if you have a trade that has a lot of margin calls, you can actually, you can reduce the economic viability of that trade and reduce what your goals have been to provide the solution to your clients.

Jockle: So one of the questions, when I think back to one of the webinars that Anna Barbashova did earlier, she suggested the concept that Cheapest-to-Deliver though isn’t always optimal, and we’re talking about something that is very specific to the curve, so building curves into the valuation process yet, how should that be interpreted especially when thinking about the broader collateral management process?

Davis: So in terms of, if you look at the Cheapest-to-Deliver curve, what that really gives you is a snapshot of the market today, and what it looks like you should be posting for collateral through the lifetime of your trade. When she says that’s not optimal, the story a bit more complex, in that the collateral posting, the cheapest on a daily basis can actually be trade dependent and also depends on market movements, so really the full solution you’d have to build up a collateral management system that daily you look at the markets, then in the future, in order to see what you’re going to put on in that given trade, you need to know all the counterparty information, the whole netting set with your different counterparties as well as the correlation of the collateral securities you’re able to post with the trade itself.

That’s why on the buy side it’s a complex operation that they’re not in the position for most of the buy side firms to scale up that operation, so they look to solutions and third party vendors to do that. The Cheapest-to-Deliver though is a good piece of information that tells you over the lifetime of your book, what you’re likely to post in terms of the currencies and securities you have on hand.

Jockle: Well Tom thank you so much for the clarification I appreciate the time today. Follow Tom on twitter; join him on LinkedIn as well as Numerix on twitter@nxanalytics.com. Let’s get your feedback as well, let’s hear you on the blog, and reach out to us because we want your opinion. Tom, thank you so much and enjoy your sunny Vancouver day, and we’ll see you on the channel again next time. Thank you.

Davis: My pleasure Jim.

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Improving Risk Management and Transparency for Structured Products

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