Jul 19, 2012

OIS Discounting: The Increasing Complexity of Curve Construction

Curve construction in ‘the new world’ has become increasingly complex ?even when it comes down to vanilla deals. As part of our ongoing series on the impact of Overnight Index Swaps (OIS) discounting on valuation approaches, Numerix recently hosted a webinar examining the more technical aspects of OIS discounting and curve construction.

Market practitioners in the process of moving to the multi-curve approach are feeling the pressures of new pricing and valuation challenges.  Increasingly, we are talking to practitioners with outstanding questions related to OIS discounting and the particularities of curve construction in both the single-currency and cross-currency worlds.  So, why are there so many questions right now? We’ve come to realize that accurate and adequate curve construction is still only part of the equation.

During this webinar, Anna Barbashova, Business Analyst at Numerix, examines curve construction practices in different jurisdictions in a multi-curve framework, cross-currency curve construction and the pricing of non-linear interest rate structures.

The Complexity of CSA Agreements

Ms. Barbashova kicks-off the discussion with an analysis of the incredible complexity of existing Credit Support Annex (CSA) agreements. She highlights their many embedded optionalities and variations, adding that, “each agreement is basically unique because of the huge amount of inbuilt options.”  We are all aware of the lack of transparency, and the fact that valuation discrepancies abound?even for the most simple trades. So, how can we expect consistent valuations, when it is basically impossible to compare prices between dealers?

Moving Toward a Solution

As many of us know, the new ISDA CSA agreements (which several banks will start using in couple of months) require that every trade will be allocated to one of 17 silos, based on the currency of the underlying trade, which is basically the same as the LCH.Clearnet approach. Counterparties will be required to post CASH collateral ONLY in that currency, and trades will be discounted using the appropriate OIS rate or alternative, if OIS doesn’t exist. All other currencies will be allocated to either USD or EUR buckets.

Despite some criticism, many market participants do believe that the new ISDA CSA should resolve the discrepancies in counterparty valuations and eliminate the necessity of cheapest-to-deliver modeling ?while (hopefully) boosting liquidity in the OIS market. Let’s keep our fingers crossed. Some folks fear the new CSA may slow the initial development of new agreements and predict problems with cross-currency settlement risk?despite potential solutions proposed, such as a Payment-versus-Payment settlement system (PvP) and netting collaterals into a single currency (implied swap adjustment).

Curve Construction Complexities Explored

We observe some of the curve construction complexities firsthand, when Ms. Barbashova takes us through several examples of single and cross-currency curve constructions.

The example below highlights the single currency curve construction for the FedFunds curve, and compares the advantages and disadvantages of three different OIS curve stripping methods. (Note: These techniques are relevant only for the USD market, where the challenge is that liquid OIS quotes are not available after the 5-year mark.) Therefore, some solutions should be implemented to obtain the long end of the curve.  

Single Currency Curve Construction: FedFunds Curve

BlogGraphicCurveSlide19 

A Closer Look at Cross-Currency Curve Construction

Ms. Barbashova also explores cross-currency curve construction, wisely pointing out that even in a single-curve setting, cross-currency curve construction involves three curves. The example below highlights the dramatic and increasing complexity of cross-currency curve construction in a multi-curve setting, which can result in the use of up to seven curves!

BlogGraphicOISSlide36

The Impact on Derivative Valuations

Overall, we need to keep in mind that an interest rate curve essentially evolves into an interest rate “surface” based on tenor and credit quality and that curve construction, and volatility surface construction need to incorporate OIS discounting. The “right” discounting curve, depends on the credit quality of the self, the counterparty and the netting and collateral clauses in the CSA.

We need to also understand that even in the absence of collateralization, modeling funding costs explicitly is a must, due to the divergence among different funding rates (various Libor tenors, OIS, Repo, etc). Even in the presence of collateralization, “imperfect” CSAs result in CVA, DVA and FVA exposures that need to be factored in to the valuation!

Access the webinar replay now, including demonstrations of specific construction practices in different jurisdictions in a multi-curve framework; cross-currency curve construction; and the pricing of non-linear interest rate structures.

Contact marketing@numerix.com if you have any further questions or require additional information.

Related Reading:

OIS Discounting: More on Facing the New Level of Complexity

OIS Discounting and OTC Derivatives: Demystifying the Confusion

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