Calypso’s David Kelly talks about some of the challenges posed by the OIS discounting of derivatives transactions
The financial crisis drummed home that the overnight indexed swap (OIS) rate should be used to discount cash-collateralised derivatives. Banks had previously discounted everything at Libor, even though many realised the OIS curve should theoretically be used for cash-collateralised trades instead, as this determines the interest rate paid on that collateral.
This practice began to change during the crisis, as the basis between Libor and OIS blew out massively - making it clear that Libor couldn't be relied upon as a catch-all discount rate. As a result, the large dealers started to move to OIS discounting, with the relevant rate determined by the currency of the collateral being posted.
However, this has led to a variety of other difficulties - largely stemming from the optionality embedded in the existing credit support annex (CSA) document. Each set of counterparties can agree on a list of eligible collateral they will post to each other, as well as the threshold at which they will start to post. This means virtually no two CSAs are identical: one CSA might restrict the two parties to posting dollars with a zero threshold, while another might allow the counterparties to choose between dollars, euros, US Treasury bonds and even equities with a $50 million threshold.
This makes the choice of discount rate incredibly complex. Most dealers agree the correct discount curve should be based on the cheapest-to-deliver collateral, on the assumption that counterparties will always look to post whatever asset is cheapest for them. However, what is cheapest now may not be cheapest in the future, meaning dealers need to look at the discount curves for each of the eligible collateral types, and consider what the cheapest collateral is at each point in time.
In this video interview, David Kelly, director, financial engineering at Calypso, talks about some of the challenges posed by OIS discounting, as well as some of the technology solutions on offer.
More on Derivatives
Regional organisation takes first step on road to rubber futures
OTC clearing service in Europe and US may face the chop
US bank parts company with 15-year veteran who moves to the buy side
Isda AGM: increased cost of hedging biggest concern in end-user survey
Sign up for Risk.net email alerts
Sponsored video: MarketAxess
Sponsored video: Tradeweb
Multifonds talks to Custody Risk on being nominated for the Post-Trade Technology Vendor of the Year at the Custody Risk Awards 2014
Sponsored webinar: IBM Risk Analytics
There are no comments submitted yet. Do you have an interesting opinion? Then be the first to post a comment.