muRisQ Advisory offers quantitative finance advisory services. Its services focus on trainings and workshops, benchmark transitions, interest rate model development and validation, product design and risk management strategies.
Marc will present at the Benchmark Congress organised by CEETA in Warsaw 15-16 May. Most of the congress will be held in Polish and focus on the WIBOR transistion.
Marc's presentation will be divided in two parts
and
Don't hesitate to contact us if you require advisory related to the benchmark transitions.
On Thursday and Friday, Marc was presenting a workshop on “multi-curve and collateral framework and IBOR transition”.
Among the slides presented was this one:
This is a back-of-envelop computation of IM funding cost (Margin Value Adjustment - MLA) to take advantage of the CCP basis. This computation leads to a 1.5 bps annualized at each CCP, i.e. 3.0 bps total. The slide was presented with a graph of the recent LCH-EUREX basis in EUR done a couple of days before and showing the peak at 4 bps for the 10 year.
The same day that the slide was presented, the following article was published in Risk:
This shows that the basis, which looks like an arbitrage, is very difficult to monetize, that 4 bps may not be a strong anomaly but just a feature of the market and that constraints on the market by regulators may have unintended, but not unexpected consequences.
Don't hesitate to contact us if you are interested by independent advise related to market infrastructures, initial margins and interest rate markets.
Swap rate dependent products, e.g. CMS, have a long history in interest rate modelling. They look simple as only one rate is involved, but when the rate is not paid in a natural way, i.e. not according to its own annuity, they involve some type of "convexity" or "timing" adjustment.
Those products are often priced using "replication", but to do so, some approximation of the annuity discounting, or absence thereof, is used. This type of single factor approximation is what we used in our recent paper on pricing cash settled swaption through the fallback published this month in Risk (Henrard (2022)).
A very recent paper Bang and Daboussi (2022) is proposing a new approach to price swap rate dependent products in a way that preserves the full marginal distribution of all the swaps and a user selected copula between those rates.
The implementation is not trivial from a quantitative finance perspective (two changes of measure) and implementation (Monte Carlo). But by the way the numerical approach is cleverly designed, the simulations are not too costly and converge quickly.
We have adapted the methodology proposed by the authors to take into account conventions (accrual factors not all the same and the T+2 payment/effective date) and implemented it in our library. This is the library we use for consulting and model validation purposes.
The results we have observed are very good. In their paper, the authors compare the (input) market smile to the (output) model generated smile for vanilla options and find a very small discrepancy, i.e. the numerical noise is small on the present value. We have obtained the same results. We have also done the comparison for the smile risk which was not presented in the paper. We computed the sensitivities to the alpha, beta, rho and nu parameters in a SABR model. In our implementation, the sensitivities are obtained by Algorithmic Differentiation (AD) as you would expect. For a 2Yx5Y swaption, here is the comparison between the analytic result (direct formula for the vanilla) and the Monte Carlo with AD version:
As you can see, the numerical noise is below 0.05% of the actual number on the alpha-vega (a little bit higher for nu and rho). This was obtained with a relatively low number of Monte Carlo paths (1,000).
Why we are interested by this approach, beyond its natural application to CMS, is for the above mentioned fallback of cash settled swaptions with the LIBOR-linked swap rate discontinuation.
With a precise view of the term structure smile risk in CMS-like products, we can now have a look at term structure smile risk for the fallback. That will be the subject of a forthcoming blog.
Henrard, M. (2022). Swap rate: cash settled swaptions in the fallback. Risk, Cutting Edge. Published online 1 July 2022. https://www.risk.net/cutting-edge/banking/7951001/swap-rate-cash-settled-swaptions-in-the-fallback
Bang, D. and Daboussi, E. (2022). Modelling of CMS-linked products in an RFR framework, with extension to hybrids, forward starting and canary options. SSRN 4134438. https://ssrn.com/abstract=4134438
Don't hesitate to contact us if you are interested by model developments or model validation related to swap rate linked products like CMS.
Added 2023-05-07: The implementation notes for this model have now been published in the muRisQ Advisory Implementation Notes series. See the new related post.
A couple of months ago, we announced that the research paper written by Marc and titled
had been accepted for publication in Risk. The article will appear in the June edition.
Since, that research has been deepened and we are pleased to announce that the follow-up article has been already accepted for publication in Wilmott Magazine. The article is titled
Cash-settled swaptions with collateral discounting are impacted by the Swap Rate fallback mechanisms decided by working groups/ISDA. The legacy vanilla swaptions are becoming exotic products, as the mechanism is based on a non-linear transformation of the OIS swap rate, and generate convexity adjustments. It turns out that those two effects almost cancel each other and lead to almost vanilla products. We analyse those cancelling effects and the risk management impacts. Based on those insights, we propose an adjusted fallback mechanism that reduces further the exotic features and simplify further the risk management of the legacy book.
The article should be published in the September issue.
As a teaser, the graph below describes by which factor the "exoticness" of the fallback is reduced by our proposed alternative mechanism for different market movements. All the technical details are available in the paper.
Figure 1: Reduction in "exoticness" achieved by the alternative fallback proposal.
Added 7 June 2022: A preprint version is available on SRRN at: https://ssrn.com/abstract=4130090.
Don't hesitate to contact us if you are interested by the alternative to the ISDA fallback for swap rates. Cash settled swaption fallback can be a lot simpler than the current approach. Why not simplify your transition risk at no cost?
We are pleased to announce that the research paper written by Marc and titled
has been accepted for publication in Risk. The publication date will be announced later.
The preprint version of the paper is part of the muRisQ Advisory Model Development series of research papers. The paper results have been presented in different seminars and conferences, including the The 4th Interest Rate Reform Conference on 20 October 2021.
With the planned cessation of LIBOR, the LIBOR-based Swap Rates will also cease. For legacy transactions linked to it, a fallback is required. Some approximated fallback mechanisms have been proposed by working groups. The approximations involve some non-linear function of overnight-based swap rates. Due to the non-linearity, cash settled vanilla swaptions are becoming exotic products. Moreover, keeping the annuity unchanged while changing the rate to overnight-based swap generates technical issues in the pricing leading to convexity adjustments. The article proposes different pricing methodologies for those now exotic swaptions, including several price approximation to reduce the implementation numerical complexity.
Marc was quoted in the press in an article related to the LCH steering away from ISDA fallback: Industry broadly supports LIBOR big bang switch (subscription required).
The quotes are
While the proposal crafted by LCH may look like an ideal solution for many market participants, it could come at a price, which some deem too high. “I encouraged my clients to consider this approach even before it was proposed by LCH, but we should bear in mind that clearinghouses look at what is in their books – not at the market,” said Marc Henrard, managing partner at muRisQ Advisory.. “They want to push the bifurcation problem out to end-users, who in turn will have to deal with the issue on their bilateral trades and manage the bilateral-to-cleared basis risk."
Bringing forward this proposal earlier and presenting a common mechanism that can also apply to bilateral trades would have made for a smoother process, Henrard added.and
In addition, there is a risk that LCH's solution could fragment the swaps market, as liquidity will be split between the trades referencing RFRs and those using ISDA’s fallback rates. “Market participants should make sure they have the right tools in place to compute any small residual valuation difference,” said Henrard. “LCH’s proposal may not work out to everyone’s advantage, and some may want to adjust their positions ahead of the big bang.”
Since the discussion related to the fallback have started almost three years ago, our opinion has been that the methodology proposed, in particular by ISDA, based on compounded in arrears are unsatisfactory. The compounded in arrears itself is the correct approach for overnight, but forcing an overnight in-arrears mechanism into instruments designed for term in advance rates can only lead to dangerous situations from a risk management perspective.
Marc has been quite vocal about it in his blogs and technical publications. The earlier warning can be found in his quant perspectives (proposal, July 2018 and results, January 2019) and blogs (e.g Fallback compounding in arrears won't work).
Recent presentation to clients included in particular messages like:
Don't sign the protocol, don't go through the fallback, this is a unmanageable Frankenstein.
Our advise, in the same presentation was
Fallback does not create OIS-like exposures. Better to repaper existing LIBOR swaps to OIS (even if with same spread).muRisQ Advisory presentation to a client on 17 December 2020.
There was a general believe that CCP would adopt the ISDA protocol. But in the same client discussion we said: "CCPs do whatever is the easiest for them, not what is right for the market. We still have to read the details of the CCP fallback"!
CCPs have full discretion on how to incorporate fallback.
muRisQ Advisory presentation to a client on 17 December 2020.
We invite you to (re)read of previous blog related to the reason why the proposed ISDA fallback is not acceptable in term of risk management: Fallback transformers: gaps and overlaps and its portfolio or Christmas versions.
LCH recently indicated that it does not plan to use the fallback, as described in the press and in the blog: LCH plans Libor swap switch to RFRs
CME appears to also follow our lead and suggest not to use the fallback. Today's announcement "Cleared Swaps Considerations for IBOR Fallbacks and Conversion Proposal" offers a very short overview of the conversion direction.
The discussion document ask about timing, calculation periods, coupon payment dates, and swaption exercise. Those issues have been mainly ignored in previous consultations and in the collateral/discounting big bang.
We have provided in detail analysis of all those issues to several clients, buy side and sell side. The analysis are all based on production grade code implementing all the successive versions of the fallback, including all the timing, dates and spread issues. Hopefully detailed independent analysis of those issues will be performed and made public by the CCPs.
If you want to be ahead of the transition game, contact us for LIBOR fallback and discontinuation: trainings, workshops, advisory, tools, developments, solutions.
Bespoke training for you and your team starting at GBP/USD/EUR 10,000*! *pricing dependent on topic and group size.On our side, we can say
Bespoke training for you and your team starting at GBP 3,000/day*! *pricing not dependent on topic and group size.
Agenda tailored to your needs. Detailed lecture notes.
Associated to open source code for practical implementation.
Training in English or French
We are an (fiercely) independent management owned advisory firm and the trainings reflect that independence. We don't have hidden agenda and are free of conflict of interest.
In the current situation, we are also happy to offer virtual/on-line courses/workshop. The configuration is even more flexible that in-person courses as participants in different locations can attend simultaneously and courses can be split in half days to avoid participants lassitude.
In all cases, the course are updated with the latest market information and are fully flexible.
You can check some of our introduction videos on our Youtube channel.
Note added 2020-11-30: With inflation, increased demand and increased administrative requirements, we have slightly increased our prices recently.
