Apr 16, 2012

OIS Discounting: Facing the New Level of Complexity

With many of the world’s financial institutions in the process of migrating to new market standards, questions remain as to the potential impact on existing portfolios, as well as how to effectively manage instruments with longer-dated maturities when spreads in LIBOR v. OIS rates begin to diverge.

OIS discounting and the impact of standardization in the market adds a new level of complexity when it comes to derivative pricing and risk management. “Basically, everything needs to be rethought from the beginning and must be carefully reviewed,” explained Anna Barbashova, Business Analyst at Numerix. At the moment, pricing & valuation via OIS discounting is not a consistent market standard; however, we need to keep in mind that it is not considered a market standard—‘Yet.’

Yet. A small word, that packs a powerful punch…

The swap market has already moved to the dual-curve approach, but other markets, including swaptions, caps/floors, exotics and equities are still very much still evolving. A recent Numerix case study on OIS discounting and the impact on derivatives P&L and risk calculations clearly demonstrates that the single curve and multi-curve approaches can diverge substantially in pricing and risk calculations.

The case study also illustrates that the most significant difference in pricing and risk between the two approaches is most apparent for long dated swaps, seasoned swaps, and off-market swaps. Moreover, as the case study unfolds, we come to see that the single curve approach essentially ignores OIS and spread risks together. The bottom line becomes clear: the mispricing of risk is significant when the spread increases.

Consistent valuation techniques are critical, throughout a firm and relative to the market, with front, middle and back office computational consistency a necessity. Without this consistency, market quotes and counterparty valuations will diverge, risk calculations will differ between departments, and correct hedging decisions will be compromised.

The entire interest rate pricing framework needs to be rethought from its basic concepts, including the following:

  • Curve stripping {OIS, multi-curve surface (1m, 3m, 6m, etc.), XCCY curves}
  • Volatility surfaces (from Black-Scholes vols to premiums)
  • Modeling and pricing (curve + spread)
  • Calibration
  • Risk management valuations

As part of this webinar series, read our earlier blog discussion about OIS Discounting and the evolution toward separate forecasting and discounting curves to learn more.

For more information on OIS discounting and Numerix multi-curve pricing solutions, contact marketing@numerix.com.

View a replay of the OIS discounting webinar.

And, stay tuned for our Numerix follow-up articles and webinars on OIS discounting in the near future.

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