OTC Derivative Portfolio Pricing Options for the Buy-Side OTC Derivatives Operations in Fund Management 02-Nov-2011, 09:30 session Miroslav Vanous Head of EMEA OTC Valuations (A Tullett Prebon Company)
Agenda 1. Impact of central clearing on OTC derivative valuations 2. Valuations via front office vs. third party vs. central clearing 3. In-house vs. outsourced valuation considerations 4. Developing people, processes, and systems for valuations 5. Summary thoughts 2
Central Clearing and Derivative Valuations Standard OTCs to be centrally cleared depend on regulation and technology: Dodd-Frank: scope for a broad class of [sufficiently standardised or liquid] swaps may exempt FX swaps and forwards exempts trades where a counterparty is using swaps to hedge and is not a financial entity exempts OTC derivatives entered into before July 2011 uncleared trades to be reported to a registered trade repository EMIR: scope for all types of derivatives but limited to specific underlyings may have broader end-user exemption uncleared trades to be reported to a registered trade repository uncleared trades will carry an obligation for tracking valuations 3
Some Standard OTC Derivatives Interest Rate Derivatives amortizing swaps, swaptions asset swaps auto / flexi / limit cap basis swaps, swaptions BMA/tax-exempt swaps, swaptions, caps Brazilian swaps callable caps / floors capped floater swaps, swaptions caps / floors (vanilla through highly structured) chooser flexible cap CMS spread range accruals, swaps, swaptions CMS swaps, swaptions constant maturity caps / floors cross currency swaps, swaptions differential swaps, swaptions digital caps / floors index swaps, swaptions inverse floater swaps, swaptions knock-out swaps, swaptions lookback caps / floors OIS / EONIA swaps percentage of LIBOR swaps, swaptions, caps quanto [index] swaps, swaptions range accrual swaps, swaptions snowball, snowbear, thunderball notes swaps, swaptions (vanilla) variable callable swaps, swaptions Fixed Income Securities & Derivatives amortizing bonds bank debt BMA/tax-exempt bonds bond forwards, futures bond options brady bonds callable bonds certificate of deposit commercial paper floating rate notes FRAs government & corporate bonds index-linked bonds loans MBS, ABS, CMBS, RMBS money market instruments structured notes term loans zero coupon bonds Foreign Exchange Derivatives forwards / futures FX vol swaps long-dated FX options power reverse dual currency notes and swaps (callable) swaps, swaptions 4 Inflation Derivatives inflation-linked notes & swaps cross-currency inflation-linked notes & swaps inflation-indexed swaps inflation caps/floors
Some Standard OTC Derivatives Credit Derivatives asset swaps (and callable) basket CDS, swaptions bespoke tranches cash flow CDOs with waterfall CDO tranches, notes CDS & swaptions on single names and indices constant maturity CDS credit linked notes (CLNs) credit spread options, forwards equity default swap first to default, nth-to-default, n-out-of-m defaults, all-to-default LCDS rating sensitive notes total return swaps (including Property) Equity Derivatives cliquet options correlation swaps employee stock options equity linked swaps, swaptions mountain range options (Everest, Altiplano, Himalaya) total return swaps variance & volatility swaps warrants Commodity Derivatives caps/floors forwards & futures swaps / swaptions Options (FX, equity, commodity, embedded within structured products) american / bermudan / european average price/ average strike barrier (single and double) basket binary / digital chooser compound currency translated forward start installment lookback (range, strike) multi-asset (best of, worst of, etc.) outperformance Parisian / soft barrier portfolio power quanto quotient shout spread window Hybrids (IR/FX/Credit/Equity) ASCOTs convertible bonds (regular, reverse, contingent, etc.) structured products structured baskets 5
Central Clearing and Derivative Valuations Each CCP will adopt its own valuation policies... Creates valuation inconsistency across trades cleared by competing CCPs Creates valuation inconsistency across bilateral and cleared trades Eventually (months, years?) central clearing of OTC trades will bring about a formulated process, and thus greater standardisation, for the valuation of CCP eligible trades This in turn should lead to a greater amount of consistent [vanilla] trade data that can be used in the calibration of models used to value bilateral trades, given around 60-65% of existing OTC trades will move to CCPs, with an eventual plateau being reached beyond which further standardisation is unlikely to take place Anshuman Jaswal of research firm Celent 6
Central Clearing and Derivative Valuations Post-trade OTC derivative valuations for the buy-side (bilateral)... Daily, weekly, monthly, ad-hoc Front office (indicative marks from dealer, prime broker, or portfolio manager) Middle office (internal calculations from systems & product control teams) Outsourced to a third party (fund administrator, valuation vendor) Ability to dispute ongoing collateral calls Post-trade OTC derivative valuations for the buy-side (CCP)... Daily CCP performs valuations and communicates variation margin Limited (if any) ability to dispute margin calls 7
Central Clearing and Derivative Valuations General comments on CCPs, CVA, CSAs, OIS vs LIBOR discounting... CCPs [almost] eliminate the need for CVA (credit valuation adjustment) Valuation adjustments for existing trades that could be cleared (novation)? Note possible CSA effect where IRS via CCP but swaption bilateral Valuation processes for trades that remain bilateral will not see a large impact But depending on what valuation methodologies CCPs embrace, this could lead to valuation changes for bilateral trades... LIBOR vs OIS discounting 8
Valuation Sources & Considerations Front office Arguably the best source for valuations (note executable vs. indicative) Note the potential for bias due to risk profile of specific book Central Counterparty What level of transparency is available for their margin calculations? How / why do valuations differ across CCPs for the same trade parameters? Third Party Vendors What is behind the valuation process (data, QA, automation)? Ideally each source will share their data (rate curves, volatilities) for comparisons. 9
In-house versus Outsourced Valuations Key items to consider: If trading is core to your business, you will do everything in-house Evaluate how large, complex, liquid, and dynamic your portfolio is as this should drive the decision of what valuation capabilities to build, buy, or outsource Is the decision the same for the primary and secondary valuation source? If in-house, what specifically is built from scratch versus bought? If outsourced, invest the time to conduct proper due diligence on vendors via RFPs and comparable valuation tests 10
Developing Valuation Processes All OTC derivative valuation decisions should consider requirements for: Accuracy What is your benchmark and tolerance levels? Note valuation uncertainty. Auditability What details are required for a regulator, audit, or risk team to reproduce results? Automation Manual / labour intensive processes = resource intensive with operational risk. Scalability What are the variable costs as portfolios grow? 11
Developing Valuation Processes Producing accurate, auditable, automated, and scalable valuations: 1. Market data - import, verification, cleansing / repair, interpolation / extrapolation 2. Models (ongoing validation) & methods - calibration fit and stability, calculation speed 3. Trade loading - deal economics via term sheet interpretation or formatted flat file 4. Calculations and price verification 5. Valuation and risk statistic outputs 12
Summary Thoughts Hopefully CCPs will, in time, reduce the valuation burden on certain OTCs, though valuation uncertainty doesn t tend to be material with vanilla products Bilateral OTCs will continue to require price verification independent of the counterparty or front office, and the chosen valuation solutions should align with the size / materiality and complexity of the portfolio Once you ve decided upon the requirements for accuracy, auditability, automation, and scalability, the decision of what valuation functions to outsource vs. conduct in-house should be clear 13
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