Jul 14, 2013

The True Cost of OTC Derivatives Funding - FVA, OIS and Profitability

Watch the Video: The True Cost of OTC Derivatives Funding - FVA, OIS, and Profitability

The question at the root of the OTC derivatives decision process, "Is this trade profitable?", may at its core seem like a simple proposition. But in the changing world of OTC derivatives, this culmination of calculations has become increasingly complex, especially from a funding perspective.

In this video blog, Numerix experts explore the connection between funding and profitability.

Through this discussion, we revisit fundamentals of OIS and FVA, delves into the relationship between FVA and profitability for both buy and sell-side participants, addresses the Standardized CSA and its role, and explores key pricing and funding factors to consider in understanding the true cost of funding and ultimately the profitability of a trade.

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

Video Transcript: The True Cost of OTC Derivatives Funding - FVA, OIS and Profitability

Jim Jockle (Host): Well it’s clear the rules of the derivatives game are changing. One thing that hasn’t changed is the diversity of prices being given during pre-trade transactions. The biggest question is especially as the rules are changing, what is behind those prices? With me today, Tom Davis, PhD from Numerix, how are you Tom?

Tom Davis (Guest): Doing well thanks for having me Jim.

Jockle: So Tom one of the key questions that we really want to get into and you know we’ve looked into the whole issues of OIS Discounting as the impact on valuation, but let’s talk about FVA. How is that charge, one being incorporated into the pre-trade pricing discussion, and how is that being passed along?

Davis: That’s a great question that’s really topical in the industry today. The OIS charge as we all know came about because of the multi-curve facets of the markets now that different tenors of LIBOR have a different spread. So the six month rate is no longer the twice compounded three month rate. And once this happened, we started asking the fundamental questions, what curve should we be discounting at? And there’s two answers that came about. One could be the risk-free or the proxy for the risk-free rate – which is no longer LIBOR – or it’s how you fund or how you’re actually going to fund the derivative. And especially now that we’ve moved toward centralized clearing, and collateralized trades, we see that the amount that gets passed on, has to be the OIS rate because,  if I’m in a trade with you and you owe me some cash flows in the future, you’re going to be posting collateral to me and I have to give you the OIS rate – the overnight rate – as interest. And so on the days where the cash flows happen, you can actually take that money from the collateral and you can see that’s why you need the OIS rate to be at the discounting rate. Now we know though that as the market moves the value of the derivative is not going to exactly match the amount in the collateral account. And the reason is, there are a number of reasons. One, the next cash flow happens and the derivative changes value for that reason. Two, the underlying risk factors of the derivative itself makes the derivative move. And three, we don’t mark to market the collateral account at the same frequency we do the derivative trade. So now there’s going to be a short fall or excess in the collateral account as oppose to the value of the exposure of the derivative. And so it’s really that shortfall or excess that’s going to give rise to an extra charge in terms of actually funding that derivative. So to get back to your question, “how do you pass that charge along?”, the question is more can you pass that charge along? One thing that we know for certain is that traders are going to get charged this charge from their treasury desk. However within their internal operations they go about funding this derivative, it’s going to be something they have to take into account in their P&L. So therefore at any opportunity possible, they are going to pass this trade along. So for instance if they’re on the buy side, if you go to a number of dealers you’ll probably get a number of different quotes. So if I’m on the buy side, then I go to some sell side dealers. That’s going to affect their cost of funding, reflect their cost of funding. Typically though, in that sort of situation, when there’s a lot of market participants, the price is going to be set, not by my funding and my internal bank operations, but by the laws of supply and demand. And the lowest bid is going to get the business. And so therefore, in a lot of situations the trader is not going to be able to pass that charge along.

Jockle: But looking ahead, what is the long term implication for the valuation? Right, because if I’m going to novate that at a later date, there’s clear opportunity for arbitrage and gains based off potentially the ability of one counterparty to have a better funding rate or a better pricing rate from another, if I’m a dealer.

Davis: Right that’s a great point. The fundamental issue here is “how do we report FVA even internally?”. If I have a swap on, do I put the FVA for that swap into my mark-to-market. There’s actually no consensus right now in the industry because there’s so many different practices. The situation you brought up of novation – when another counterparty will come in and step into my trade for me – that would tell me that I should be using an industry average funding rate to determine my FVA. Whereas when I’m going to hold that to the lifetime and the maturity of a derivative, I should be using my personal, or my own institution’s funding rate to determine that FVA. So it’s really, accounting regulations have not decided upon how we’re going to enforce this in reporting and in regulation reporting because there’s so much different variety. But one thing is for certain, your internal operations should know your FVA in order to know the profitability of the trades.

Jockle: Now clearly funding is correlated to collateral. And so the question that I have now, especially that we’re on the dawn of the standardized CSA, how much of this because you’ll have analogous collateral available, or limited collateral due to the silos or what’s available, how much of this is mitigated?

Davis: There’s a couple of things the standardized CSA does for mitigation. The biggest one is reducing the optionality embedded in the CSA as it exists today. They’ve introduced the seven silos so we’re always going to get the currency in one of those seven silos. They’ve also had a mechanism for how to, if your trade is not one of those silos, they introduce a mechanism for actually determining the correct rate on how to change the currency into one of those silos. So there’s no longer an optionality for posting anything but cash, and there’s no longer the optionality of changing the currency once the trade is executed. So that’s going to mitigate a lot of the difficulties in terms of calculating things like FVA, CVA, because of the optionality, and therefore how you have to value your collateral, going forward is going to be a lot simpler.

Jockle:  So quick rundown as we’re at the end of this particular segment, I’m coming into a trade, where are the question marks for me as to the pricing disparity? Give me the run down. Clearly I have to look potentially for funding, I’ve got to look at my CVA charge that’s being imposed against myself. What else should I be looking for in terms of impact of pricing and questions?

Davis: The biggest thing is going to be, “is this trade profitable?” And so a couple of factors are going to come into that. The CVA is what you charge your counterparty and that is something that in principal can be dynamically hedged throughout the lifetime of the trade. The DVA also can be agreed upon between the counterparties because it’s the CVA charge your counterparties would charge you. So that’s something that in principle that can be calculated at trade initiation. That one is a bit more difficult to hedge. Because it would involve hedging your own corporate bonds and that gets into a little bit of mire there. But the third is FVA can you pass that on? If you can you should. If you can’t you should definitely know what it is and track it on a day to day basis because that’s going to affect your profitability. And that could impact the decision on whether I want to enter into that trade or not. Especially if other dealers with lower funding rates can offer that deal at a different price.

Jockle: Well Tom I want to thank you and I think the one that’s clear is the way we’re calculating P&L in the future is dramatically changing from the way it was done in the past. So we want to hear from you. We want you to join into the debate, join into the topics, follow us along on LinkedIn, let’s hear more about this topic on twitter @nxanalytics and please feel free to engage with Tom on LinkedIn as well and thank you Tom Davis and we’ll see you next time.

Davis: Thanks Jim. 

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