Collateral Pricing PDF

Collateral consistent derivatives pricing
FRIC Practitioner Seminar, CBS
Martin D. Linderstrøm, marlin@danskebank.dk

Counterparty Credit & Funding Risk
www.danskeresearch.com
Agenda
• The intuition behind collateral consistent pricing.

− A benchmark case: A multi-currency calibration under EUR cash collateral.
• The complexities of a multi CSA book
− Which collateral assumptions hold for calibration instruments?
− The ISDA Standardized CSA approach
− Market fragmentation between CCP cleared and bilateral trades?
• Case studies in curve calibration
− What are reasonable bounds for forward curves?
− Arbitrages in fragmented markets?
• Pricing and hedging discounting risks under different CSA regimes?
− The collateral valuation adjustment.
− The cheapest-to-deliver optionality in CSAs
− Hedge ratios with and without optionality?
www.danskeresearch.com 2
Swaps in the old way
• In the “old” days (until Aug’07) many 5Y 3M-6M Basis 5Y EONIA-3M Basis
market participants had just one swap 70
curve for each currency. 60
50
− Forward rates – irrespective of tenor – were 40
calculated on this. 30
− Discount factors were also derived from this 20
curve. 10
0
• This implicitly assumes: 2005 2006 2007 2008 2009 2010 2011 2012
− No money market basis (e.g. 3s6s basis is

5Y EUR/USD X-CCY
zero).
10
− No cross currency basis (e.g. EUR/USD basis 0
is (close to) zero). -10
-20
− Traders can fund themselves at xIBOR. -30
-40
− Note that on a single curve, a Floating Rate -50
-60
Note trades at par at fixing time. -70
• These assumptions are no longer valid. -80

2005 2006 2007 2008 2009 2010 2011 2012
Swaps in the new way
• Need for multiple projection Forward LIBOR Surface
curves for each currency. 2.5%

2.0%
1.5%
23-Aug-10
− We cannot compute 3M xIBOR and 6M
29-Nov-10
7-Mar-11
15-Jun-11
1.0%
21-Sep-11
29-Dec-11
5-Apr-12
xIBOR forwards on the same curve. 0.5%
17-Jul-12
23-Oct-12
1-Feb-13
0.0%
15-May-13
10M
21-Aug-13
5M
• Need for a single discounting
1B
curve for each currency.
− This should reflect CCS spreads.
1.2 Discount Factors
− But what should be my anchor in terms 1.0
of currency and credit premium? 0.8
0.6
− If your trade is collateralised, you should 0.4
discount with the collateral rate. 0.2
− What is your collateral rate? 0.0
The institutional setting
• The ISDA Master agreement

− The legal umbrella underpinning netting.
− Default and early termination provisions.
• ISDA Definitions
− Sets standards for methodologies such as settlement of options, application of floating
rates etc.
• ISDA Credit Support Annex (Credit Support Deed)

− Defines the terms for collateralisation.
− Sets Thresholds, Independent Amounts, Mininmum Transfer Amounts and valuation
frequency.
− Eligible collateral and specifies interest earned.
The intuition behind collateral consistent pricing
Flow analysis: EUR Derivative - EUR Cash collateral
T0: Payment (=+100 EUR) Bank
T0: Payment (=+100 EUR)
Counter Party Trading Desk

T0: Contract
(PV=-100 EUR)
T1: Interest= RIntern*(1/360)*100 EUR
T1: Contract Cash Desk

(PV=-100*(1+ RDisc/360) EUR)
T1: Interest= REUR/OIS*(1/360)*100 EUR T1: Interest= RIntern*(1/360)*100 EUR
Collateral
T0: Payment (=+100 EUR) Management T0: Payment (=+100 EUR)
•Cash desk is passing through the liquidity – no •For the setup to be arbitrage free, the trader needs to
haircuts or disagreement on valuation. be discounted at the rate his cash position earns, i.e.
•Internal loop can be ”closed” if rIntern=rOIS RDisc = ROIS.
•See Piterbarg (2010). •He could in principle hedge his cash exposure via an
EONIA swap.
A benchmark case: A multi-currency calibration under EUR
cash collateral
• Stylised market: EUR: 3M forward rates
− Only IRSs against 3M xIBOR. EUROIS EUR3M
− 3M xIBOR-OIS basis swaps. 3.5%
− X-CCY basis swaps against 3M XIBOR.

3.0%
− Only swap instruments 1-30Y.
• Setup 2.5%
− Separate forward and discounting curves. 2.0%
− Single collateral assumption – all products

are EUR cash collateralised. 1.5%
− Want a CCS consistent valuation setup.

1.0%
• Approach
0.5%
− Calibrate jointly EUR3M and
EUROIS=EURDISC curves.
0.0%
0 60 120 180 240 300 360
Forward start (months)
Benchmark case – cont’d
• Approach cont’d: USD: 3M forward rates

− Calibrate jointly USD3M, USDOIS and 3.5% 0.0%
USDDISC curves...
3.0%
− ...requires EUR model as input since -0.1%
X-CCY legs have initial PV... 2.5%

− ...USDDISC curve is not dependent on -0.2%
USDOIS. 2.0%
• Pricing implication 1.5%

-0.3%
USDOIS
− This creates a X-CCY dependence for -0.4%
USD3M
the pricing of every USD cashflow. 1.0%
USDDISC
− Hedging tool for USD net liquidity is to EUR/USD X-CCY 3M (rhs.) -0.5%
0.5%
trade USD fixed-EONIA float CCS…
− …this delivers the required EONIA 0.0% -0.6%
floater to collateral mgmt. 0 60 120 180 240 300 360
The intuition behind collateral consistent pricing (cont.)
Flow analysis: EUR Derivative - USD Cash collateral

T0: Contract T1: Interest= (REUR/OIS+s)(1/360)*100 EUR
(PV=-100 EUR)
T0: 100 EUR
T1: Contract Cash Desk CCS Counter Party
(PV=-100*(1+ RDisc/360) EUR)
T0: 126 USD
T1: Interest= RUSD/OIS*(1/360)*126 USD T1: Interest= RIntern*(1/360)*126 USD
T1: Interest= RUSD/OIS*(1/360)*126 USD

Collateral
T0: Payment (=+126USD) Management T0: Payment (=+126 USD)
•To produce the collateral posting in USD an •The discount rate needs to reflect the spread in the
Eonia/Fed-Funds CCS is entered. CCS.
•Notice that there is a spread s on the EUR leg! •In reality there may be multiple currencies, and
•See Piterbarg (2012). hence a cheapest-to-deliver option for the collateral
poster!
Calibration instrument assumptions
• Fundamentals
− What do we mean by calibration instruments?
− Our model tells where to price one product reletive to others…
− …so we should calibrate it market prices at which we can execute hedges.
• ”The Market”
− How is ”The Market” collateralised?
− No single answer…
− …CSAs are bilateral agreements – and they vary substantially.
− CCP collateralisation rules are however very clear.
• My calibration should depend carefully on the collateral assumptions that I will face
once I start using the calibration instruments for hedging.
− Each market segment offers one source of risk – but can be collateralised differently:
− On several CCPs EUR trades are EONIA collateralised, USD trades are FF collateralised…
− …the same goes for the ISDA Standardised CSA.
− But what holds true for FX products?
Changing the assumptions
• Back to USD: USD3M Fwd: EONIA vs. Fed Funds based

− Let us instead calibrate by using Fed Funds discounting…
3.5% 0.25
− …most of ”The Market” for USD swaps clears via LCH…
− We are using the same market quotes for spot 0.00
instruments… 3.0%
− …but see slight changes in the 3M Fwd curve for 3M USD -0.25
LIBOR.
2.5%
• Intuition: -0.50
− A par-swap rate is a weighted average of xIBOR forward
rates. 2.0% -0.75
− Changing the discounting assumption alters the weighting
of the individual fwd xIBOR rates. -1.00
1.5%
− A typical swap market calibration has many degrees of
freedom. EONIA based -1.25
calibration
• Conclusion: 1.0%
Fed Funds based
calibration -1.50
− Depending on your assumptions, you can easily misprice
forward starting swaps with 1.0-1.5 bps. 0.5% Diff (bps), rhs
-1.75
− This is huge in a market that trades with bid-offer spreads
in the 0.25-1 bps range.
0.0% -2.00
0 60 120 180 240 300 360
Changing the assumptions – cont’d
• Cross currency swaps: CCS 3M fwd breaks: EONIA vs. Fed Funds based
− The same effect holds true for CCSs. 0.0% 0.10
− In most markets, the fwd curves for the CCS
breaks are less steep than xIBOR fwd curves… 0.05
-0.1%
− …this means that the discounting effect is 0.00
smaller.
• ISDA Standardised CSA: -0.2%
EONIA based calibration
-0.05
− Is promoting USD cash collateral for FX products -0.10

Fed Funds based calibration
incl. CCS…
-0.3% Diff (bps), rhs -0.15
− …so Fed Funds discounting must be right…
-0.20
− …but what about the fwd curves needed to price
up this product? -0.4%
-0.25
This introduces a multi-step calibration
requirement… -0.30
-0.5%
…need to calibrate ”silo” models first and -0.35
subsequently introduce a new discounting curve.
-0.6% -0.40
0 60 120 180 240 300 360
Changing the assumptions – cont’d
• An aside on CCSs: CCS 3M fwd breaks: Difference to Fed

− The basic building block for CCSs is in 0.25
Funds (bps)
itself tricky…
− …MtM FX resets or constant notionals?
− Should FX-Basis correlation be included?
− Does the market standard CCS product 0.00
rather warrant a full hybrid model?
• Conclusion:
− The full sequential calibration of the silo-
based model matters in certain curve -0.25
segments.
− Is obviously dependent on interpolation EONIA based calibration
settings…
Silo based calibration
− …but for plausible choices, the difference in
a 5Y5Y EUR/USD CCS can be up 0.25 -0.50
bps. 0 60 120 180 240 300 360
The intuition behind collateral consistent pricing
Flow analysis: EUR Derivative - EUR security collateral

T0: Contract
(PV=-100 EUR)
Cash
T1: Contract Cash Desk Repo Cpty.
(PV=-100*(1+ RDisc/360) EUR)
Bond
Collateral T1: Interest= RRepo *(1/360)*100 EUR
Bond Management Bond
•Security collateral can be financed at their respective repo rate.

•Note the role of haircuts: Cash desk potentially receives one, but collateral management will have to
provide one in the CSA. Only differences in haircuts matter – and then becomes a question of
unsecured funding rates.
Case study: Potential for market fragmentation in SEK
• CCP vs. Bilateral: SEK3M: Fwd curve diffs (bps)

− Clearing is not standard in all markets – yet. 3.5
− In SEK, a large share of the IRS market is cleared
STINA-Fed Funds
but much is still bilateral. 3.0
STINA-EONIA
− Among the market makers security collateral is
allegedly common place… 2.5
STINA-STIBOR
− …and some of this is closer to STIBOR funded. 2.0
• CCP valuation vs. cash accrual 1.5
− LCH.SwapClear uses STIBOR discounting for VM
calculation… 1.0
− …but still pays T/N rate on SEK cash.
0.5
− First order (accrual rate) vs. second order
(accrual balance) effect.
0.0
• Conclusion:
-0.5
− If there is still only one broker price, there should
be fragmentation in the forward swap market.
-1.0
− Screen prices should be different. 0 60 120 180 240 300 360
Collateral valuation adjustments
• CSA optionality:
− Many (older) CSAs contain long lists of eligible collateral.
3M forward EURDISC rates
− If collateral can be freely substituted, this creates a Fed Funds based calibration EONIA based calibration
cheapest-to-deliver option for the posting party.
3.5%
− This creates a need for an effective discount curve –
created from more than one curve. 3.0%
• Example:
2.5%
− Can choose between placing EUR cash earning EONIA and
USD cash earning Fed Funds.
2.0%
− This is effectively a series of call options on the EONIA-FF
CCS spread.
1.5%
• Intrinsic value of CSA option:
− Find the upper convolution of the EONIA disc curve and 1.0%
the Fed Funds adjusted curve (in fwd terms).
0.5%
− Use these forward rates to generate effective discount
curve.
0.0%
− In the specific example, it is expected to be cheapest to
deliver EUR for all 30Y years...
-0.5%
− …but there is a risk that USD will be cheaper.
-1.0%
0 60 120 180 240 300 360
Expected collateral flow – 100M EUR 20Y IRS Payer
• Net Flow Flow

1,000,000
− Take forward Euribor rates and par 800,000
fixed rate as given, assume EUR OIS 600,000
400,000
discounting. 200,000
Flow Rec
Flow Pay
− Forward curve is upward sloping 0
-200,000 Flow Net
-400,000
− We pay out net the first 5 years, and -600,000
receive net the last 15 years. 0Y 5Y 10Y 15Y
• Future Value as expected FV

collateral balance. 40,000,000
35,000,000
− Starts and ends at zero for the ATM 30,000,000
trade. 25,000,000 FV Rec
20,000,000
FV Pay
− Increses since we are owed more and 15,000,000
FV Net
more. 10,000,000
5,000,000
− Decreases when we start to receive. 0
0Y 5Y 10Y 15Y
Forward Cross Currency Basis Spreads – 1Y Forward CCS next 20Y
• ColVA Flow ColVA

0.000% 10,000
− Consider the Collateral Valuation -0.100% 8,000
Adjustment if collateral should be -0.200%
6,000
posted in USD Cash rather than EUR -0.300% CCS Spread
4,000 Flow ColVA
Cash. -0.400%
-0.500% 2,000
− User the FV Net as the CCS notional -0.600% 0
profile, compute the value of paying the 0Y 5Y 10Y 15Y
spread.
FV ColVA
− The spread is determined through the 8,000,000 250,000
CCS with the Fed Funds rate flat on the 7,000,000
200,000
one leg and Eonia plus a spread on the 6,000,000
5,000,000 150,000
other. 4,000,000 FV Net
3,000,000 100,000 FV ColVA
2,000,000
50,000
1,000,000
0 0
0Y 5Y 10Y 15Y
Discount Curve Risk wrt 1Y Forward CCS Spreads - 100M EUR 20Y IRS Payer
• Compute Discount Curve Risk Disc Risk

2,000 0.00%
wrt. 1Y Fwd swaps to derive 1st 1,000
-0.20%
0
order ColVA impact estimate -1,000 -0.40%
-2,000
from shifting collateral type. -3,000 -0.60%
• Example continued: ATM Disc Risk OTM Disc Risk

ITM Disc Risk CCS Spread
− ATM, ITM (ATM-100bp), OTM(ATM+100bp)
− Positive FV implies negative Fwd Disk 1st Order ColVA: Disc Risk * CCS Spread
Risk. 150,000
100,000
− ITM/OTM have the extra disk risk from 50,000
an annuity. 0
-50,000
− Result: ATM OTM ITM -100,000
Impact Impact Impact

ATM Impact OTM Impact ITM Impact
203k EUR -356k EUR 761k EUR
Option adjusted collateral consistent pricing
• Realised volatility on CCS spreads: EONIA-FF CCS:

Rolling 30D realised volatility (annualised)
− Spot (normal) volatility is in the 20-50 bps 0.80%
range on an annualised basis. 5Y 10Y
0.60%
− Forward spreads are however less volatile.
0.40%
• How to include volatility? 0.20%
− Simple model, can only EUR or USD cash.
0.00%
− Assume Gaussian model. Feb-10 Aug-10 Feb-11 Aug-11 Feb-12 Aug-12
− Collateral poster is long a series of caplets

on CCS breaks, struck at 0 bps. 3M forward EURDISC rates
• Conclusion 4.0%
Intrinsic 20 bps vol 50 bps vol
− Given the shape of the CCS fwd break 3.0%

curve, the short expiries are deep OTM… 2.0%
− …little effect on effective discounting curve. 1.0%
0.0%
− But significant increases for long dated 0 60 120 180 240 300 360
expiries (closer to ATM and higher vega). Forward start (months)
Option adjusted collateral consistent pricing – cont’d
• Theory: Intrinsic (0 bps): CCS Dv01 (EUR)

− Fujii & Takahashi (2011) and Piterbarg (2012)
Base +10 bps +20 bps
• Example: 30,000
− 30Y EUR Payer, 100m 250 bps OTM.
25,000
• Risk:
− Using the intrinsic approach, not CCS hedge 20,000
is required (EUR trade, EUR cash is CTD with
certainty). 15,000
− But this will change as basis spreads 10,000

increase  Risk will ”jump”.
− Stability in hedges is an important argument 5,000
for developing CTD models…
0
− …especially in ”naive” bump-and-re-run” mode.
-5,000
Model PV Initial Difference
Intrinsic CTD -46.67m - -10,000
Option adj. CTD, 20 bps -45,80m 878k
Option adj. CTD, 50 bps -43.92m 2.756k -15,000
1Y 2Y 3Y 4Y 5Y 7Y 10Y 12Y 15Y 20Y 25Y 30Y
Note, this is a typical pension fund trade – a difference
of 6% of the PV of derivatives can mean insolvency.
Option adjusted collateral consistent pricing – cont’d
Option adj (20 bps): CCS risk (EUR) Option adj (50bps): CCS risk (EUR)
Base case +10 bps +20 bps Base case +10 bps +20 bps
15,000 15,000
10,000 10,000
5,000 5,000
0 0
-5,000 -5,000
1Y 2Y 3Y 4Y 5Y 7Y 10Y 12Y 15Y 20Y 25Y 30Y 1Y 2Y 3Y 4Y 5Y 7Y 10Y 12Y 15Y 20Y 25Y 30Y
• Option adjusted discount deltas: USD cash only: CCS risk (EUR)
Base case +10 bps +20 bps
− Results in stable hedges.
25,000
− Intuition fits well against USD cash- 20,000
15,000
only benchmark case.
10,000
5,000
0
1Y 2Y 3Y 4Y 5Y 7Y 10Y 12Y 15Y 20Y 25Y 30Y
Conclusion
• There is a direct link between collateral terms and discount factors.

• This is important – it is not just for market makers in derivatives.
• It is not trivial to construct collateral consistent swap curves – and
arbitrages are sometimes not far away.
• The ”poor man’s” collateral consistent approach can bring most market
participants far.
• While the value of CTD options embedded in CSAs is debatable – the
risk implications are clear.
References
• Piterbarg, V. (2010), ”Funding beyond discounting: Collateral

agreements and derivatives pricing”, Risk Magazine February, pp.97-
102
• Fujii, M. & Takahashi, A. (2011), ”Choice of collateral currency”, Risk
Magazine January, pp. 120-125
• Piterbarg, V. (2012), ”Cooking with collateral”, Risk Magazine, pp. 58-63
Disclosure
This presentaitonhas been prepared by Danske Research, a division of Danske Bank A/S ("Danske Bank").
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Collateral consistent derivatives pricing

FRIC Practitioner Seminar, CBS

Martin D. Linderstrøm, marlin@danskebank.dk

• The intuition behind collateral consistent pricing.

− No money market basis (e.g. 3s6s basis is

• These assumptions are no longer valid. -80

• Need for multiple projection Forward LIBOR Surface

curves for each currency. 2.5%

of currency and credit premium? 0.8

− What is your collateral rate? 0.0

• The ISDA Master agreement

• ISDA Credit Support Annex (Credit Support Deed)

T0: Payment (=+100 EUR)

Counter Party Trading Desk

T1: Contract Cash Desk

T1: Interest= REUR/OIS*(1/360)*100 EUR T1: Interest= RIntern*(1/360)*100 EUR

− X-CCY basis swaps against 3M XIBOR.

− Separate forward and discounting curves. 2.0%

− Single collateral assumption – all products

− Want a CCS consistent valuation setup.

• Approach cont’d: USD: 3M forward rates

X-CCY legs have initial PV... 2.5%

• Pricing implication 1.5%

T0: Payment (=+100 EUR)

Counter Party Trading Desk

T1: Interest= RUSD/OIS*(1/360)*126 USD

• Back to USD: USD3M Fwd: EONIA vs. Fed Funds based

− Is promoting USD cash collateral for FX products -0.10

• An aside on CCSs: CCS 3M fwd breaks: Difference to Fed

T0: Payment (=+100 EUR)

Counter Party Trading Desk

Collateral T1: Interest= RRepo *(1/360)*100 EUR

Bond Management Bond

•Security collateral can be financed at their respective repo rate.

• CCP vs. Bilateral: SEK3M: Fwd curve diffs (bps)

• Net Flow Flow

• Future Value as expected FV

• ColVA Flow ColVA

• Compute Discount Curve Risk Disc Risk

• Example continued: ATM Disc Risk OTM Disc Risk

Impact Impact Impact

• Realised volatility on CCS spreads: EONIA-FF CCS:

− Collateral poster is long a series of caplets

− Given the shape of the CCS fwd break 3.0%

• Theory: Intrinsic (0 bps): CCS Dv01 (EUR)

− But this will change as basis spreads 10,000

• There is a direct link between collateral terms and discount factors.

• Piterbarg, V. (2010), ”Funding beyond discounting: Collateral

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T1: Interest= REUR/OIS(1/360)100 EUR T1: Interest= RIntern(1/360)100 EUR

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