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Collateral Discounting: Rethinking the Interest Rate Pricing Framework from its Basic Concepts

Company: Numerix LLC

Numerix LLC case study

Category: Credit Risk

Published: 25 September 2013

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Overview

With the 2008 crisis a catalyst for significant change, market practitioners witnessed the tremendous increase in basis swap spreads, implying a divergence from implied rates and traded rates in interest rate markets. Collateral disputes rose dramatically as counterparties began discounting at the overnight rates dictated by the credit support annexes-the world had forever changed.

As a result, many financial institutions are currently in the process of migrating to new market standards; but, questions remain as to the potential impact on existing portfolios and how to effectively manage instruments with longer-dated maturities when spreads in LIBOR v. OIS rates begin to diverge.

This article examines how a swap portfolio's value differs under the single and multi-curve approaches at four different snapshots in time-including pre-crisis, at the height of the crisis, post-crisis and today. The case studies in this article also highlight risk sensitivities under the two approaches and how swap moneyness and maturity factor into the calculations over a period of time from 2006-2012.

 

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Categories related to Credit Risk