Thursday, 17 January 2019

LIBOR fallback: a recognised expertise

Over the coming years, one of the main issues in interest rate trading and risk management will be the emergence of new benchmarks and the potential IBORs fallback.

In the past year, we have looked at those issues from a theoretical and from a practical point of view. Some of the theoretical issues are detailed in a note that Marc published recently called "A Quant Perspective on IBOR Fallback Consultation Results" (https://ssrn.com/abstract=3226183). On the practical side we have implemented different fallback options, curve calibration mechanism and convexity adjustment to analyze the impacts on large portfolios. Some descriptions of the tools are available in a series of previous blogs.

Our expertise has been recognized by the market as indicated from the invitations to most of the quantitative finance conferences in Europe over the next months. Marc has been invited as guest speaker or expert panelist at the following events:
  • The future of LIBOR (CFA Society Denmark, Copenhagen, Denmark) - 24 January 2019
  • CASS Financial Engineering seminar (CASS Business School, London, UK) - 6 February 2019
  • Quant Summit (organized by Risk.Net, London, UK) - 6-7 March 2019
  • QuantMinds International (Vienna, Austria) - 14-16 May 2019
  • Risk Live (organized by Risk.Net, London, UK) - 27 June 2019
We are also presenting in-house workshops on similar subjects (see our training page on LIBOR) at different financial institutions in Europe.

Don't hesitate to contact us if you want to discuss potential in-house training or providing expertise on this subject for your projects.

Marc's presentation at CASS Financial Engineering workshop

Marc Henrard will present a seminar at the CASS Financial Engineering workshops. The presentation will take place on Wednesday 6 February 2019 at 6:10 pm.

Marc's talk, will be titled  
A quant perspective on LIBOR fallback.

Talk's abstract:
With the increased expectation of some IBORs discontinuation and the increasing regulatory requirements related to benchmarks, a more robust fallback provision for benchmark-linked derivatives is becoming paramount for the interest rate market. Several options for such a fallback have been proposed and ISDA held a consultation on some of them. The results of the ISDA consultation has been to select the ``compounding setting in arrears" option. We analyse the proposed option in details and present an alternative option supported by different working groups. The presentation focuses is on the quantitative finance impacts for derivatives. To our opinion, the option selected by the consultation fails the basic achievability criterion in many cases. Even when achievable, the option can lead to significant value transfer and risk management complexities. We also explain to which extend the fallback may transform some vanilla instruments into exotics.

Thursday, 10 January 2019

Updated Quant perspective on LIBOR fallback

The note on IBOR fallback in our series Market Infrastructure Analysis as been updated with the results of the ISDA consultation. The note, titled

A quant perspective on IBOR fallback consultation results,

is available on SSRN: http://ssrn.com/abstract=3308766

Abstract

With the increased expectation of some IBORs discontinuation and the increasing regulatory requirements related to benchmarks, a more robust fallback provision for benchmark-linked derivatives is becoming paramount for the interest rate market. Several options for such a fallback have been proposed and ISDA held a consultation on some of them. The results of the ISDA consultation has been to privilege the ``compounding setting in arrears" option. This note, which can be view as the version 2.0 of a previous note, presents the different options briefly and analyses the privileged option in details. It also presents an alternative option supported by different working groups. The note's focus is on the quantitative finance impacts for derivatives. To our opinion, the option selected by the consultation fails the basic achievability criterion in many cases. Even when achievable, the option can lead to significant value transfer and risk management complexities.

Tuesday, 1 January 2019

MVA and cost of funding

In the previous blog on Margin Value Adjustment (MVA), we have shown that, for linear products, the forward Initial Margin (IM) along the different paths of Monte Carlo simulation may not be very different. This was visible in Figure 2 of the previous blog.

The IM level is only one half of the MVA, even if this is the one that is often the most computationally intensive. The other half is the cost of funding the IM. For illustration purposes, we use in this blog a cost of funding equal to the spread between OIS over a quarterly period and LIBOR. Obviously each institution need to had some idiosyncratic spread on top of that. But for illustration purposes, this simplified approach is enough.

When we have generated the paths on which we have computed the IM, we have used an interest rate model. Even if our portfolio contained only interest rate swaps linked to a unique IBOR rate, it is important to generate the paths with a model that take into account the stochastic spread between IBOR and OIS in a realistic way. The spread is used in the valuation/IM measurement, but more importantly in our case it is also used in the cost of funding computation. This is why the model used should match the current spread, take into account the spread dynamic (volatility) and have a realistic co-dependence (correlation) between IBOR and OIS curves.

For this blog, we have used a relatively simple model that fulfills those requirements: an hybrid Model for the Dynamic Multi-Curve Framework as described in a recent Model Development document. The model includes the spread stochasticity and the correlation between rate level and spread. For the examples we provide below, the model has been calibrated to USD cap/floor for the IBOR rates dynamic and to historical spreads and correlations behavior.

We first repeat the underwhelming graph which represent the IM level of our portfolio (with a small number of paths).




Figure 1: An example of forward IM paths for a swap portfolio.


For the same paths, we have computed the quarterly cost of funding as the USD-LIBOR-3M/OIS-3M spread applied over the quarter to the IM. The cost are reproduced in the graph below. The colors for each path are the same in both graphs.



Figure 2: An example of IM cost for a LIBOR-OIS related funding cost.

As appears clearly in that graph, the spread has more impact on the MVA than the precise IM level. In modelling term, it is very important to have a realistic multi-curve model with stochastic spread to which a good understanding of the dependence of the idiosyncratic institution specific funding spread should be added.



Other blogs on IM and MVA: