Oil price models, IM changes and VAR caps

The week on Risk.net, May 16-22, 2020

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Bachelier – a strange new world for oil options

Model tuned to negative prices has implications for pricing, margining and delta hedging

CFTC advisory body backs six-month initial margin ‘grace period’

Majority vote to recommend extra six-month extension for phases five and six of initial margin rules

Experts find holes in funds’ argument for higher US VAR caps

Ex-SEC official says he would be “shocked” if agency raised proposed leverage limits on derivatives users


COMMENTARY: Lessons from strange days         

This week Risk.net looked at how market behaviour during the pandemic is undermining some fundamental assumptions about how pricing works.

WTI crude fell into negative pricing in April – not only unprecedented, but literally unthinkable for most market participants. The widely used Black-Scholes option pricing model was unable to cope, and two major commodity exchanges switched to the older Bachelier model – a move which, participants say, has highlighted some other shortcomings of Black-Scholes, especially in turbulent markets.

Meanwhile quants must decide how to handle the outbreak of negative oil prices. Incorporating it into models could impair performance in normal times (if and when normal times re-establish themselves), but ignoring it as a one-off freak moment could be foolhardy.

A paradoxical move in Vix futures pricing could be a valuable warning of the next market panic – though there’s doubt over whether the relationship will hold in future. The problems with this kind of warning are twofold: first, of course, in general as soon as an indicator is made public it starts to become less reliable, as the market starts to trade on it. And second, verifying any indicator of impending crisis has the problem that crises are rare and so the datasets available for constructing and testing the indicator are very sparse (and if the datasets start to become less sparse, then there will be other problems).



Aggregate operational risk-weighted assets (RWAs) at the eight US global systemically important banks fell by $5.7 billion over the first three months of 2020 to $1.86 trillion. San Francisco-based lender Wells Fargo saw its op RWAs fall the most, by $2.9 billion (-1%) to $335 billion. Morgan Stanley followed with a reduction of $1.8 billion (-2%) to $100 billion. Though Covid crisis rages, US banks’ op RWAs fall



“There’s no change in the position we’ve taken previously on compelling [Libor] panel bank participation. We struck the deal with panel banks that they would stay until end-2021 and there’s no sign that anyone is not going to honour that. For our part, we have no intention of compelling banks thereafter” – Edwin Schooling Latter, UK Financial Conduct Authority

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