The proliferation of collateralised trading in response to the recent crisis has thrust the debate between OIS and LIBOR discounting into the limelight. Bob Emerson, head of Interest Rate Derivatives at SuperDerivatives explores the evolution and current implementation of OIS discounting curves
While Overnight Index Swaps (OIS) have been used for years, the credit crisis and subsequent events have dramatically increased both the use and liquidity of these trades due to the widespread use of OIS curves to discount primarily LIBOR (or LIBOR equivalent) based derivative trades.
With the fall of Bear Stearns and Lehman Brothers and the near collapse of the worldwide banking system, dealers and users of derivatives are paying far more attention to the counterparty credit risk inherent in any OTC derivative transaction.
This has manifested itself in two primary ways: more widespread use and tighter terms of Credit Support Annex (CSAs) (a CSA specifies the terms of collateralisation between two derivative trading counterparties), and a broad move toward valuing derivative transactions in a manner that is consistent with those CSAs.
More specifically, virtually all new CSAs are being written with zero thresholds and daily posting. Furthermore, since most CSAs (and, by the way, the central clearing models of both the CME Group and LCH.Clearnet) specify cash collateral earning overnight interest, the perception of “correct” discounting of future derivative cash flows has moved from LIBOR- based discounting to OIS-based discounting.
While this move has taken the better part of two years, currently most top derivative dealers have moved to OIS-based discounting for cash-collateralised trades.
Both the CME and International Derivatives Clearing Group (IDCG) revalued their swaps portfolios OIS rates at the end of 2011, following a move by LCH.Clearnet’s SwapClear to discount US dollar, sterling and euro interest rate swaps using OIS.
The CME said the decision to revalue portfolios in this way was driven by a need to reflect current market practice and to eliminate valuation basis between OTC and exchange-traded instruments.
Still, the “readiness” of end users for the move to collateral- based discounting varies widely, and the technology available to end users for this move has been much more limited than for large dealers with huge IT and research budgets.
Third party valuation vendors like SuperDerivatives offer the option to use OIS discounting within their systems, fed by live and historical market data across an ever growing list of currencies.
Practically speaking, most derivatives trades, other than those used for corporate hedging, fall under very low threshold, frequently posted CSAs. Most of these CSAs specify that collateral posted or held must earn interest at overnight rates (e.g. the Fed fund in the US, EONIA in Europe, etc).
However, if collateral accounts earn and pay OIS rates, it follows that discounting derivatives trades on LIBOR is inconsistent.
While this inconsistency has existed in the derivatives market for years, the proliferation of collateralised trading in response to the recent crisis has thrust this issue into the limelight.
Fundamental changes in the methods of valuing derivatives can only take place if a wide enough group of participants (particularly dealers) are ready to make that change (otherwise the dealer community would become susceptible to arbitrage by end users).
Discounting LIBOR-based cash flows on OIS curves has not been straightforward to implement. If a user simply discounts known flows and expected flows projected from a traditionally built LIBOR curve on an already built OIS curve, this does not correctly re-price market-quoted LIBOR based swap rates.
The user must instead co-bootstrap the LIBOR and OIS curves to correctly re-price LIBOR-based swaps.
The methodology favoured by the largest liquidity-providing derivatives dealers is to throw away traditional LIBOR projection curves, and re-bootstrap those curves so that they re-price market quoted swaps when those swaps are discounted on OIS curves.
This results in LIBOR forward rate projections that are different from those obtained in a single curve LIBOR only model.
The greatest practical effect that all of this has on derivatives pricing is on the mark-to-market (MTM) of deep in or out of the money swaps. This means that termination values and MTM of deep in or out of the money swaps quoted by dealers can be significantly different from the expectations that end users who do not MTM based on OIS discounting have.
To illustrate this, consider a seasoned EUR 500mil notional swap with a received fixed coupon of 6.5% and a remaining maturity of 20 years.
As of 3/14/2011, this swap would have a MTM under LIBOR discounting of ~184.9mm. Under OIS discounting, this swap would have a MTM of ~190.2mm. Differences for shorter, less away from the money swaps would be proportionately smaller.
In order for end users of interest rate derivatives to MTM swaps consistently with the dealer community and to have correct expectations of termination valuations of their collateralised swap trades, those MTMs should be generated using LIBOR/OIS co-bootstrapped technology consistent with that used by their swap dealers.
While there will certainly be more changes in the fundamentals of derivative valuation in the future (for example, correct discounting for “cheapest to deliver” multi-currency collateral agreements or for non-cash collateral), the current industry wide push is for the buy side to catch up to the sell side on technology and infrastructure supporting single currency, cash collateral OIS based discounting.
What is OIS?
The overnight indexed swap (OIS) is an interest rate swap where the OIS floating leg is set by reference to a daily overnight reference rate, rather than by reference to a short-term published reference rate.
From SuperDerivatives Glossary
