Avoiding Collateral Surprises: Managing the Embedded Optionality of Multi-Currency CSAs

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December 4, 2012

Avoiding Collateral Surprises:

Managing the Embedded Optionality

of Multi-Currency CSAs

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About Us

Our Presenters:

Anna Barbashova

Business Analyst, Numerix

[email protected]

Jim Jockle

SVP Marketing

(3)

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Agenda



Collateral management and optimization



CSA existing and future



Cheapest-To-Deliver and Optionality



XCCY Curve Construction



CSA and CTD construction



Pricing portfolio

o

Cash, T-bonds, Corporate Bonds

(5)



Collateral management and optimization



CSA existing and future



Cheapest-To-Deliver and Optionality



XCCY Curve Construction



CSA and CTD construction



Pricing portfolio

o

Cash, T-bonds, Corporate Bonds

(6)

Why collateral management is important?

Why now?

 Increased usage of collateral as a way to mitigate risk of counterparty default

 Divergence of rates after the crisis and complex CSAs

 Collateral shortage

 Equally important for sell-side and buy-side

 Choice of collateral significantly affects derivative pricing

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Central Collateral Management Process

What is the purpose of central collateral management

process

&

why identifying CTD is necessary:

 Profit!

 Effectiveness!  Liquidity

 Beneficial to post CTD (cheapest-to-deliver)  Minimize funding costs

 Maximize return

 Bigger choice of collateral

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Central Collateral Management Process

Central collateral management process

challenges

:

 New system:

o Each business in the firm – separate systems different architecture

o Different systems and process for each desk in OTC

 Validate ALL CSAs – lost in translation  Dedicate group to manage

 Keep track of huge flow of collaterals  Big data input requirement

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Is Cheapest = Optimal?

Is cheapest collateral always the most effective one?

 Massive amount of rules and requirements depending on

o Funding rates

o Available assets

 Get rid of excess of existing asset

 Is cheaper to source new collateral or use existing one?

(10)



Collateral management and optimization



CSA existing and future



Cheapest-To-Deliver and Optionality



XCCY Curve Construction



CSA and CTD construction



Pricing portfolio

o

Cash, T-bonds, Corporate Bonds

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Complexity of CSA Agreements

Current CSA agreements:

 Almost each agreement is unique

o Choice of collateral currency

o Big list of eligible collaterals

o Various termination dates and events

o Different thresholds

 Lack of transparency

 Valuation discrepancies between counterparties for simple trades

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Future Standardized CSAs

New standard ISDA CSA agreements:

 17 silos

o Like clearing houses

o Easier to add

o Easier to take out

 Cash ONLY

 Discount with OIS or proxy of OIS  All others to USD or EUR buckets  No rehypothecation

(13)

Standardized CSAs

Difficulties with Standardized CSA:

 Dollar dominance

 Two systems in parallel – for old and new

 Cross-currency settlement risk (PVP vs Netting)

(14)

Standardized CSAs

Should resolve:

 Discrepancies in counterparty valuations

 Cheapest-to-deliver modeling and optionality

 Addition of new currencies

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

Collateral management and optimization



CSA existing and future



Cheapest-To-Deliver and Optionality



XCCY Curve Construction



CSA and CTD construction



Pricing portfolio

o

Cash, T-bonds, Corporate Bonds

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How to construct CTD?

Steps:

1. Construct appropriate curves – OIS, Swap, Basis Curves, XCCY curves

2. Translate curves in different currencies to the trade currency 3. Pick cheapest through out the life of the trade

4. Construct blended CTD curve

5. Discount cash flows with CTD curve

EASY?

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How to construct CTD?

Collateral: Cash

Currencies: USD, EUR, GBP, JPY, CHF, CAD

!!! 6 cash collateral currencies = 29 Curves to build !!! USD

USD_OIS

USD_3m USD_3m6m

EUR EONIA_OIS EUR_6m USD-EUR_3m-3m EUR_3m GBP SONIA_OIS GBP_6m USD-GBP_3m-3m GBP-6m3m JPY TONAR_OIS JPY-6m USD-JPY_3m-3m JPY-3m6m CHF TOIS_OIS CHF_6m USD-CHF_3m-3m CHF_3m CAD CAD_OIS CAD_3m USD-CAD_3m-3m CAD_6m

Trade Currency - USD

Collateral Type – Cash

USD_OIS Implied SONIA_OIS _{in USD} Implied EONIA_OIS _{in USD} Implied TONAR_OIS _{in USD} Implied TOIS_OIS in _USD Implied CAD_OIS in _USD

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Cheapest-To-Deliver and Optionality

What to be aware of:

 Choice of currency and collateral type  Calibration

 Initial margin, up and down thresholds, minimum transfer amounts

 Consistency with counterparty  Cross currency debate

• See Numerix webinar: “Impact of OIS Discounting – Valuation Approaches re-examined”

• Alan Brace

“Primer: The FST Theorem for Pricing with Domestic or Foreign Collateral”*

“Primer: Curve Stripping with Full Collateralization”*

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

Collateral management and optimization



CSA existing and future



Cheapest-To-Deliver and Optionality



XCCY Curve Construction



CSA and CTD construction



Pricing portfolio

o

Cash, T-bonds, Corporate Bonds

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Cross Currency Curve Construction – CC Basis Swap

Cross-Currency Basis Swap – single curve world:

Cross Currency Basis Swap – multi curve world:

Domestic Float Leg

Ym Index DomCCY Projection

Curve _{Ym Swap Dom Yield Curve} Discount

Curve

Foreign Float Leg

Zm Index ForCCY + Spread Projection

Curve

Zm Swap For Yield Curve

Discount Curve

Implied Zm/Ym For/Dom Basis Curve

Domestic Float Leg

Ym Index DomCCY Projection

Curve

Ym Swap Dom Curve (OIS)

OIS Dom Curve

Foreign Float Leg

Zm Index ForCCY + Spread Projection

Curve

Zm Swap For Curve

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Cross Currency Curve Construction – Multi-Curve

How to obtain CC Implied Foreign Basis Curve?

 Bootstrap from FX Forward

 Assumption: both markets moved to OIS

 Bootstrap from CC OIS Basis Swaps

 Assumption: instruments exist and liquid (not yet true)

 Bootstrap from CC Basis Swaps and FX Forwards (or CC ND Swaps)

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Cross Currency Curve Construction – Multi-Curve

Instruments to bootstrap the curve:

Steps:

1. Get domestic OIS curve 1. OIS FedFunds Curve

2. Get domestic projection curve 2. 3m USD Libor Curve (OIS FedFunds Curve)

3. Get domestic projection curve for the underlying tenor

3. n/a

4. Get foreign OIS curve 4. OIS Mutan Curve

5. Get foreign projection curve 5. 6m JPY Libor Curve (OIS Mutan Curve)

6. Get foreign projection curve for the underlying tenor

6. 3m JPY Libor Curve (JPY Basis swaps & OIS Mutan Curve)

7. Solve for implied foreign basis discount curve given FX Forwards, CC Basis Swaps, 1,3 (if n/a then 2), 6 (if n/a then 5)

FX Forwards USD/JPY (up to 5y)

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Cross Currency Curve Construction – Multi-Curve

Steps to strip implied foreign discount curve from CC Basis Swaps & FX Forwards:

Domestic OIS Curve

Domestic Projection Curve

Domestic Basis Curve

Foreign OIS Curve

Foreign Projection Curve

Foreign Basis Curve

FX Forwards CC Basis swaps

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Cross Currency Curve Construction – Multi-Curve

Date 21-Aug-2012

-1.50% -1.00% -0.50% 0.00% 0.50% 1.00% 1.50% 2.00% 2.50% 3.00% 20 12 20 13 20 14 20 15 20 16 20 17 20 18 20 19 20 20 20 21 20 22 20 23 20 24 20 25 20 26 20 27 20 28 20 29 20 30 20 31 20 32 20 33 20 34 20 35 20 36 20 37 20 38 20 39 20 40 20 41 20 42

3m Forward Rates

Implied CC USD/JPY Basis Curve

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

Collateral management and optimization



CSA existing and future



Cheapest-To-Deliver and Optionality



XCCY Curve Construction



CSA and CTD construction



Pricing portfolio

oCash, T-bonds, Corporate Bonds

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Types of collateral and how to approximate

Collateral types and corresponding curves:

Steps:

1. Construct appropriate curves – OIS, Swap, Basis Curves, XCCY curves

2. Translate curves in different currencies to the trade currency 3. Pick cheapest through out the life of the trade

4. Construct blended CTD curve

Collateral Curve

Cash OIS Curve

Treasury Bonds OIS Curve

Corporate Bonds Libor + Spread

USD

USD_OIS

USD_3m USD_3m6m

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Curve construction

1. Construct appropriate curves – OIS, Swap, Basis Curves, XCCY curves

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Curve construction

2. Translate curves in different currencies to the trade currency 3. Pick cheapest through out the life of the trade

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What does your CTD tell you?

 Deterministic

 Unique for each trade

 Snapshot as of today

 Frequency window – how often do you switch collateral

 Analysis tool to identify cheapest collateral

 Value the trade with collateral switch assumption

 Match counterparty

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Cheapest-To-Deliver Construction Summary

Summary:

 Extremely tedious

 6 currencies – 29 curves

 Different curves to approximate Cash, Treasury Bonds, Corporate Bonds

 Sensitive to interpolation and smoothing

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

Collateral management and optimization



CSA existing and future



Cheapest-To-Deliver and Optionality



XCCY Curve Construction



CSA and CTD construction



Pricing portfolio

o

Cash, T-bonds, Corporate Bonds

(32)

Pricing cases



Pricing portfolio

Case1

. Par swaps with different currency cash collateral

Case2.

IR Swaps with cash vs corp bonds collateral

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Pricing Case 1: IR Par Swaps USD

Setup:

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Pricing Case 1: IR Par Swaps USD

Price par swaps with different cash collateral assumptions + CTD:

 Pricing to par under USD cash collateral ( FedFunds curve)  Significant difference for longer maturity swaps

 Range from 0-3bps running and 0-72bps upfront

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Pricing Case 2: Portfolio of IR Swaps

Setup:

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Pricing Case 2: Portfolio of IR Swaps

Setup:

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Pricing Case 2: Portfolio of IR Swaps

 Corporate bonds collateral is cheaper

 Haircuts

 Assumption – all swaps have the same CSA terms

 Snapshot as of today

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Pricing Case 3: IR Swaps in EUR and JPY

Portfolio of IR Swaps in EUR:

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Pricing: Summary

 Choice of collateral significantly affects price of the trade

 Helps to analyze counterparty numbers & assumptions

 Pricing with CTD = assumption that counterparty posts always cheapest collateral

 Pricing with deterministic CTD = assumption no costs, thresholds, min transfer amounts, etc.

 Affects amount of collateral to be posted

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Summary: What Did We Cover Today

What did we look at:

• How to construct XCCY curves in multi-curve framework

• How to translate different type of collaterals into curves

• How to construct deterministic CTD curve for multi-CSAs

• How CTD curve helps to pick appropriate collateral

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Conclusion

 Central collateral management system is important

o Cheapest-to-deliver tool to analyze

o Cheapest is not always optimal

o Should include rules and requirements on top

 New Standard CSA should eliminate optionality, but

o Implementation is only starting

o Still need to handle existing CSAs

(42)

About Us

Our Presenters:

Anna Barbashova

Business Analyst, Numerix

Jim Jockle

SVP Marketing

(43)

Thank you

Visit us online at:

www.numerix.com

Jim Jockle

Anna Barbashova

Avoiding Collateral Surprises: Managing the Embedded Optionality of Multi-Currency CSAs

December 4, 2012