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Marking to Market of Over-night Index Swaps (OIS)

Author: Nandlal Bhatkar

Nandlal Bhatkar heads Pyxis Systems Pvt Ltd (www.pyxis-it.com), which provides
comprehensive risk management software called RisKompass. He also heads Origin risk
Management (www.origin-rm.com), a leader in derivatives training, advisory and provides front
office derivatives pricing tools. Origin also provides tool for managing portfolio of Overnight Index
Swap.

Email: Johnny.bhatkar@pyxis-it.com

Abstract: With the volume picking up in the INR OIS Swap market this question troubles lots of
user. Players in the market use different methods to mark to market (MTM) the OIS swap and
that sometimes results in different values. The blame for the difference is usually given to the
methods.

This paper compares 2 methods used by the market and proves that they are equivalent. It also
provides a third method which is far elegant and easier for doing MTM.

Background:

Before we start exploring these methods, let’s create a backdrop for doing MTM of any swaps.

Working out MTM of swap is very straight forward, provided you have the discount factors. I
assume, you are using some boot-strapping method for generating the discount factors along
with suitable interpolation method for generating discount factors for in between dates.

MTM of swap involves only looking at the future cash flows. The process can be described as
follows:

Step 1: Generate the cash flows (floating cash flows are generated using the Forward rate) by
multiplying Principal, Day Count Fraction and Floating or Fixed rate. Assign positive sign to cash
inflows and negative sign to the out flows.

Step 2: Use appropriate discount factors for multiplying the generated cash flows to work out the
present values (PV). Sum of all the PVs is the MTM value.

There is a simple trick to figure out PV of floating side, provided the benchmark tenor is same as
either the payment tenor or compounding frequency (eg 3m Libor paid quarterly or O/N index
compounded daily). This can be done by taking difference of the first discount factor and the last
discount factor and multiplying this difference with the principal. The logic behind this can be
derived from the valuation of FRN (floating rate notes)
Let’s look at an FRN (Floating Rate Note)

Principal in flow

floating coupons

Principal out flow

NPV of a new FRN is zero provided the floating rates are set in advance and the benchmark
tenor is same as payment and floating rate reset frequency. The floating rate should have no
margin.

Give this we can say that PV (FRN) = PV (Principal) + PV (Coupons).

If the PV (FRN) =0 then it implies that PV (Coupons) = - PV (Principal)

PV (Coupons) = - PV (Principal) = DF start date x Principal – DF end date x Principal


= Principal x (DF start date – DF end date)

DF is Discount factor for the appropriate date.

With this back ground we are ready to tackle the OIS MTM problem.

Method 1:

This seems to be the most commonly practiced (and the most complex) method:

Step 1: Work out accrued floating interest amount till date

Step 2: Work out accrued fixed amount till date

Step 3: Add accrued floating amount to the principal amount only for the current coupon (rest of
the coupon stays at the same original swap notional principal amount). This is used for
calculating the PV of floating side.

Step 4: Work out the PV of floating side (either by generating FRA or taking the Discount factor
difference method). The principal for the current coupon is adjusted as given in step 3

Step 5: Work out the discounted value of the Accrued floating interest amount and add it to the
floating side PV. Discounting is done using the Df for the next coupon date.

Step 6: Work out the Fixed side PV for the residual tenor (first coupon will have a stub)
Step 7: Add the discounted value (discounted using the DF for the next coupon date) of the fixed
side interest accrual. Add it to the fixed side PV generated in step 6

Step 8: Net out the Fixed side PV vs Floating side PV for generating the MTM

Method 2:

Split the swap into 2 parts viz: accrued part and residual tenor

Step 1: Work out the PVBP for the residual tenor

Step 2: Work out the Fixed rate for residual swap

Step 3: Work out the difference between Original fixed rate and the fixed rate generated in step 2
and multiply it by the PVBP. This is the PV of the future portion of the swap.

Step 4: Add floating accrued amount and discounted value of the fixed accrued amount
(discounted using the Df for next coupon date) to the PV obtained in step 3. This is the MTM.

Method 3:

Step 1: Work out PV of the fixed side (start date is last coupon payment date). This can be easily
done by generating all future fixed cash flow and multiplying it by appropriate DF.

Step 2: Work out PV of the floating side from today till end of the swap. Can be done by
multiplying Principal x (1 – DF end date)

Step 3: Add accrued floating amount to the PV of floating side (generated in step 2)

Step 4: Your MTM is difference between PV of fixed (step 1) and PV of floating (step 3)

Method 3 is very simple and elegant, but rarely seen anyone using it. The most practiced method
(method 1) is an un-necessarily complex way of working simple solution out.

All the 3 methods have been demonstrated below and it is proved that they give same MTM
value.
Deal Description:

Today: 28-Apr-06

Start Date: 19-Apr-2006


End Date: 19-Apr-2008
Notional: Rs 250,000,000
Fixed Rate: 6.5% (we receive)
Floating Rate: Daily compounded Mibor
Coupons: semi /semi , floating side daily compounded
Day count basis: Act/365

Accrual Amount

Floating: Rs 400,000.00
Fixed: Rs 400,684.93

Date DF
19-Apr-06 1.000000000
19-Oct-06 0.972289675
19-Apr-07 0.943046174
19-Oct-07 0.913559755
19-Apr-08 0.884830091
Method 1:

Accrued Floating: Rs. 400,000 (daily compounded from MIBOR rate fixing data)
Accrued Fixed: Rs 400,684.93 (obtained by 250,000,000 x 9/365 x 6.5%)

Principal for next floating coupon = 250,400,000


Principal for remaining 3 floating coupons = 250,000,000

PV of floating side 1st coupon = 250,400,000 x (1-0.972289675) = 6,938,665.38


PV of floating side remaining 3 coupons = 250,000,000 x (0.972289675-0.884830091)
= 21,864,896.00

Sum of above PVs = 6,938,665.38+21,864,896.00 = 28,803,561.38

Discounted value of the floating accrued interest = 400,000 x 0.972289675 = 388,915.87

Total PV of the floating side = 28,803,561.38 + 388,915.87 = 29,192,477.25

Finding PV of Fixed side:

This is relatively easy

Cpn Pmt Days DCF Rate Principal Coupon Cash Flow DF Pv of C/F
28-Apr-06
19-Oct-06 174 0.47671 6.50% 250,000,000 7,746,575 0.972289675 7,531,915.22
19-Apr-07 182 0.49863 6.50% 250,000,000 8,102,740 0.943046174 7,641,257.70
19-Oct-07 183 0.50137 6.50% 250,000,000 8,147,260 0.913559755 7,443,009.10
19-Apr-08 183 0.50137 6.50% 250,000,000 8,147,260 0.884830091 7,208,941.05

PV 29,825,123

Accrued Fixed Interest

19-Apr-06 9 0.02466 6.50% 250,000,000 400,684.93


28-Apr-06

Discounted Value of Accrued fixed 389,581.82


(multiply by 0.972289675)

Total PV Fixed side 30,214,704.89

PV Floating: - 29,192,477.25 (we pay floating hence this number is negative)


PV Fixed: 30,214,704.89

MTM = 1,022,227.64
Method 2:

Accrued Floating: Rs. 400,000 (daily compounded from MIBOR rate fixing data)
Accrued Fixed: Rs 400,684.93 (obtained by 250,000,000 x 9/365 x 6.5%)
st
Discounted value of accrued fixed = 389,581.82 (as shown in earlier 1 method)

Fixed rate for the residual swap:

PVBP (Present value of 1 bps for the residual swap starting 28-Apr-06 to 19-Apr-08)

Date DCF DF PVBP


28-Apr-06 1.000000000
19-Oct-06 0.476712329 0.972289675 11,587.56
19-Apr-07 0.498630137 0.943046174 11,755.78
19-Oct-07 0.501369863 0.913559755 11,450.78
19-Apr-08 0.501369863 0.884830091 11,090.68

45,884.80

PV of floating side, residual tenor = 250,000,000 x ( 1- 0.884830091) = 28,792,477.25


Fixed rate for residual swap = 28,792,477.25 / 45,884.80 (PV float / PVBP)
= 627.4948 basis points or 6.275%

Thus fixed side is in the money by 6.50% - 6.274948% = 22.5052 bps

MTM of the residual swap = 22.5052 x PVBP = 22.5052 x 45,884.80 = 1,032,645.82

Adjust for the accrual = Accrued floating +PV of accrued fixed


= 389,581.82 -400,000 = -10,418.18

Total MTM = MTM of residual swap + Adjusted accrual


= 1,032,645.82-10,418.18 = 1,022,227.64

Total MTM = 1,022,227.64

This is same as found by the first method


Method 3

PV of floating side residual tenor = 250,000,000 x ( 1- 0.884830091) = 28,792,477.25


PV of fixed side (no accrual is taken) = 30,214,705

Cpn Pmt Days DCF Rate Principal Coupon Cash Flow DF Pv of C/F
19-Apr-06
19-Oct-06 183 0.50137 6.50% 250,000,000 8,147,260 0.972289675 7,921,497.04
19-Apr-07 182 0.49863 6.50% 250,000,000 8,102,740 0.943046174 7,641,257.70
19-Oct-07 183 0.50137 6.50% 250,000,000 8,147,260 0.913559755 7,443,009.10
19-Apr-08 183 0.50137 6.50% 250,000,000 8,147,260 0.884830091 7,208,941.05

PV 30,214,705

Accrued Floating Interest = 400,000

MTM = PV float (should be negative) + Accrued float (negative amt again) + PV fixed
= - 28,792,477.25 – 400,000 +30,214,705

Total MTM = 1,022,227.64

The MTM calculated here is same as that found by the first 2 methods.

All 3 methods give the same result. However method 3 is far easier to work with and is very
elegant.

Other issues:

It has also been observed that market players interpolate between 1 year swap rate and 2 year
swap rate for working out 18 month swap rate, which in turn gets used in boot-strapping process,
if boot strapping is done on yield.

18 month interpolated rate should be worked out after converting 1 year rate into semi annual
rate (i.e. price a 1 year semi/semi swap from the given set of discount factors)

Market quotes 1 year rate on annual basis and 2 year rate on semi annual basis and hence 18
month semi annual rate can not be interpolated directly from the market data.

Disclaimer:

Views expressed here are of the author’s only and not of the companies he represents.
Information herein is believed to be reliable but author does not warrant its completeness or
accuracy. Opinions and estimates constitute his judgment and are subject to change without
notice. Past performance is not indicative of future results. This material is not intended as an
offer or solicitation for the purchase or sale of any financial instrument.