Read more: http://www.risk.net/risk-magazine/feature/1932795/clearing-house-lchclearnet#ixzz1E9kHjGTO
LCH Clearnet very deservedly won Clearing House of the Year 2010 at the Risk awards. One key reason cited by Risk magazine for the award was LCH's conversion in mid 2010 to OIS discounting on its IRS valuation methodology.
The 'industry consultation' cited in the above article was conducted by LINKS Risk Advisory. In fact, LINKS Risk Advisory was advising OIS discounting was coming to the derivatives market over 3 years ago.
The cutting edge never stops moving: OIS discounting, having revolutionised interest rate swap valuation, is now causing a wholesale rethink of how currency derivatives are valued as well as how CSA's will be drafted in the future. Issues like these can have a major impact on a derivative's value and any trader of derivatives, buy or sell side, would do well to understand the impact of these issues thoroughly to eliminate the risk of arbitrage. Furthermore, considering the implications of Dodd-Frank, these issues will continue to impact buy and sell side derivative users for a while to come.
Happy hunting,
Andy
Wednesday, February 16, 2011
Wednesday, October 6, 2010
OTC to CCP
OTC to CCP - the regulatory derivatives revolution is about to arrive with a bang.
In the next few months the CFTC and SEC will release new rules that will shape the world's derivative markets for years to come. The worlds derivatives markets are holding their collective breath to see how the markets will react and evolve in response to what is the greatest revolution in derivatives trading since the introduction of the 'interest rate swap'.
Clearing houses are working hard behind the scenes to prepare themselves to offer products in anticipation of which derivatives will have a 'mandatorily cleared' tag on them. Derivative end users themselves are slowly realising that the relationships with their dealers will be unrecognisable after the new regulation is introduced.
So what should a casual blogger with a unique window into the world of derivatives and risk management say in a blog?
Prepare. And prepare with a chaotic theme in mind.
No one can confidently predict where these rules will be pitched and what their ultimate effect will be on the market. Over the coming year, the derivatives market will descend into a state of orderly anarchy. SEF's will fight it out, as will CCPs. Open interest will ebb and flow. The winners will slowly rise to the surface and will probably be evident come this time next year. They will also be those with experience and those with a sound operational record. As Graeme McDowell will tell you, the cream always rises to the top, even when the hopes of an entire continent are resting on a single man's shoulders. If you want a prediction, follow the talent,
Happy hunting,
Andy
In the next few months the CFTC and SEC will release new rules that will shape the world's derivative markets for years to come. The worlds derivatives markets are holding their collective breath to see how the markets will react and evolve in response to what is the greatest revolution in derivatives trading since the introduction of the 'interest rate swap'.
Clearing houses are working hard behind the scenes to prepare themselves to offer products in anticipation of which derivatives will have a 'mandatorily cleared' tag on them. Derivative end users themselves are slowly realising that the relationships with their dealers will be unrecognisable after the new regulation is introduced.
So what should a casual blogger with a unique window into the world of derivatives and risk management say in a blog?
Prepare. And prepare with a chaotic theme in mind.
No one can confidently predict where these rules will be pitched and what their ultimate effect will be on the market. Over the coming year, the derivatives market will descend into a state of orderly anarchy. SEF's will fight it out, as will CCPs. Open interest will ebb and flow. The winners will slowly rise to the surface and will probably be evident come this time next year. They will also be those with experience and those with a sound operational record. As Graeme McDowell will tell you, the cream always rises to the top, even when the hopes of an entire continent are resting on a single man's shoulders. If you want a prediction, follow the talent,
Happy hunting,
Andy
Thursday, June 17, 2010
The BOE late to the CVA party.....
http://ftalphaville.ft.com/blog/2010/06/15/261671/of-cva-and-sovereign-cds/
The BoE, who are now the new financial regulators, seem to have spotted that derivative businesses have things called "CVA" desks which dynamically manage counterparty risk. Given that the first CVA desk started almost 15 years ago, there is a worrying lag between a key market development and policy makers catching up.
CVA desks are undoubtedly the "good guys" when it comes to derivatives trading. It should also be noted that there was a strong positive correlation between the age of a bank's CVA desk and its share price performance during the credit crunch.
Policy makers should spend considerable time in understanding what it is CVA traders do and then wholeheartedly support them. The CVA desk has arguably been the only oasis of sanity in many derivative businesses, now is the time to let these desks flex their muscles.
Happy hunting,
Andy
The BoE, who are now the new financial regulators, seem to have spotted that derivative businesses have things called "CVA" desks which dynamically manage counterparty risk. Given that the first CVA desk started almost 15 years ago, there is a worrying lag between a key market development and policy makers catching up.
CVA desks are undoubtedly the "good guys" when it comes to derivatives trading. It should also be noted that there was a strong positive correlation between the age of a bank's CVA desk and its share price performance during the credit crunch.
Policy makers should spend considerable time in understanding what it is CVA traders do and then wholeheartedly support them. The CVA desk has arguably been the only oasis of sanity in many derivative businesses, now is the time to let these desks flex their muscles.
Happy hunting,
Andy
Friday, June 4, 2010
OIS vs Libor discounting
Hi,
Blogging has been a draw upon our time that we haven't been able to afford of late but I thought I'd comment briefly on one of the issues currently rippling through the derivatives market.
Derivatives as a business model is going through something of a revolution at the moment. There are several issues which are fundamentally changing the market and keeping the risk managers busy. One of which is typically referred to as the OIS vs Libor discounting issue.
The single curve Libor valuation model, that was largely ubiquitous across the City for valuing swaps, has been exposed as being significantly flawed. One of the issues with this model is that it didn't take into account the economic impact of the requirement to post collateral at the OIS rate against a swap's mtm. This obligation has a significant impact on the true economic value of the swap and whereas in the past this obligation was effectively ignored, new valuation techniques are now springing up based on Libor indexed cash flows, discounted at OIS. While the difference between the models is typically slight for par swaps, the difference for ITM / OTM swaps can be massive. Furthermore, we all know what happened to this spread during the Lehman default, making these differences in value a potentially major problem during volatile markets.
We are consulting on this issue in a number of areas, in fact one of our employees played a key role in seeding this issue into the market over 5years ago. Perhaps not surprisingly LINKS is finding much confusion in the asset management space on this topic. Currently, LINKS is advising that this change, albeit a slow one, is almost certainly going to persist and ultimately become normal market practise. Valuing derivatives accurately is a much more complex business than people have previously assumed it to be. Discounting cash flows to accurately represent what will be in a bank account upon realisation of derivative linked cash flow is a tricky process that requires consideration of a number of complex risks beyond a simple Libor deposit rate.
The era of complexity is here to stay,
Happy hunting,
Andy Shaw
Blogging has been a draw upon our time that we haven't been able to afford of late but I thought I'd comment briefly on one of the issues currently rippling through the derivatives market.
Derivatives as a business model is going through something of a revolution at the moment. There are several issues which are fundamentally changing the market and keeping the risk managers busy. One of which is typically referred to as the OIS vs Libor discounting issue.
The single curve Libor valuation model, that was largely ubiquitous across the City for valuing swaps, has been exposed as being significantly flawed. One of the issues with this model is that it didn't take into account the economic impact of the requirement to post collateral at the OIS rate against a swap's mtm. This obligation has a significant impact on the true economic value of the swap and whereas in the past this obligation was effectively ignored, new valuation techniques are now springing up based on Libor indexed cash flows, discounted at OIS. While the difference between the models is typically slight for par swaps, the difference for ITM / OTM swaps can be massive. Furthermore, we all know what happened to this spread during the Lehman default, making these differences in value a potentially major problem during volatile markets.
We are consulting on this issue in a number of areas, in fact one of our employees played a key role in seeding this issue into the market over 5years ago. Perhaps not surprisingly LINKS is finding much confusion in the asset management space on this topic. Currently, LINKS is advising that this change, albeit a slow one, is almost certainly going to persist and ultimately become normal market practise. Valuing derivatives accurately is a much more complex business than people have previously assumed it to be. Discounting cash flows to accurately represent what will be in a bank account upon realisation of derivative linked cash flow is a tricky process that requires consideration of a number of complex risks beyond a simple Libor deposit rate.
The era of complexity is here to stay,
Happy hunting,
Andy Shaw
Monday, December 21, 2009
Happy Holidays and Thank You for 2009 !
Hi,
It has been a while since we last posted at Links. Life became very busy in the second half of 2009 for us and posting news items became a luxury we struggled to afford. However, as work calms down ahead of the holiday season and as thoughts turn to the new year, we just wanted to say thanks very much to all the clients who supported us in 2009. We look forward to working with you in 2010 and we also look forward to welcoming a number of potential new clients into our portfolio.
The story for 2009 was one of unusual volatililty and extreme market moves both up and down. It has been a challenging environment to say the least. 2010 no doubt will also throw up its fair share of googlies / curve balls (delete as applicable depending on Nationality) to test both businesses and investors to the limit. However, one thing remains certain, sound risk management will continue to be critical to safely negotiating an uncertain market place and will continue to drive strategy at many firms.
Enjoy the holiday season and all the best for the new year,
Andy Shaw and Mark Tomsett
It has been a while since we last posted at Links. Life became very busy in the second half of 2009 for us and posting news items became a luxury we struggled to afford. However, as work calms down ahead of the holiday season and as thoughts turn to the new year, we just wanted to say thanks very much to all the clients who supported us in 2009. We look forward to working with you in 2010 and we also look forward to welcoming a number of potential new clients into our portfolio.
The story for 2009 was one of unusual volatililty and extreme market moves both up and down. It has been a challenging environment to say the least. 2010 no doubt will also throw up its fair share of googlies / curve balls (delete as applicable depending on Nationality) to test both businesses and investors to the limit. However, one thing remains certain, sound risk management will continue to be critical to safely negotiating an uncertain market place and will continue to drive strategy at many firms.
Enjoy the holiday season and all the best for the new year,
Andy Shaw and Mark Tomsett
Monday, July 6, 2009
Green shoots but doesn't score.....
Hi,
Originally credited to Norman Lamont in a 1991 recession era speech at the Conservative Party conference, the phrase "green shoots" has been popping up everywhere recently. It even has it's own entry in the Cambridge Online Dictionary:
"Green Shoots - plural noun. (Used especially in newspapers) the firstsigns of an improvement in an economy that is performing badly."
From Baroness Vadera (who probably wishes she hadn't) to Ben Bernanke, from bank research articles to every newspaper whether pink or red topped (although the latter may have been referring to England's latest goalkeeper). However, as the burning sun torches the greenery in my garden so the "green shoots" appear to be withering. But rather than ask whether there ever were any green shoots, the more interesting question is how does the use of language and data affect our behaviour?
Social psychologists such as Kahneman, Slovic and Tversky (1) have studied how we make judgements under conditions of uncertainty. If you ask someone how likely it is that an elephant will fall out of the sky and land on their head they will tell you that the probability is (virtually) zero. Ask them again just after a five tonne African bull elephant has given them a fine centre parting (assuming they survive) and the their answer will be very different. Lotteries don't emphasise the fact that the odds of winning are tiny - they highlight the size of the payouts of recent winners.
These are just two examples of the so called "availability error" - the process of determining probability by the first thing that comes to mind. The "anchoring heuristic" describes how we determine the frequency, probability, or value of items by comparing the item to an anchor point. It appears to be relatively easy to influence the actions of individuals simply by generating numbers regardless of whether they have any relation to reality. Make the number dramatic enough and people will sit up and take notice. By the time people realise how baseless the original assertion was it's too late - it now has momentum. Ask someone (who doesn't actually know) to estimate the population of the Maldives and preface the question by asking whether it is more or less than one million. The actual number is much less but the average guess will be around this figure - the anchor point. Financial numbers can be manipulated in the same way. Unrealistic price targets, growth forecasts, etc, can easily become anchors. If the true figure turns out to be very different the market reaction can be severe even thoughthe original forecast should simply have been discounted more heavily.The problems caused by the "anchoring heuristic" can be exacerbated by the "confirmation bias". This is a tendency to find data that supports an hypothesis and ignore data that rejects it.
If you believe that a particular stock rises on a certain phase of the moon you'll make note of the rises when this phase occurs and ignore rises at other times. Doing this frequently reinforces the belief in this relationship.
These heuristics exist because they save us time. Why bother doing the research when a simple rule-of-thumb will suffice? However, failing to acknowledge their clear weaknesses can easily lead to irrational investment decisions. When someone starts talking of "green shoots" or any other phrase du jour look before you leap. Question their motivation and check to see if the supporting data stacks up. As the old saying goes, invest in haste and repent at leisure.
(1) Kahneman, D. Slovic, P and Tverskty, A. eds. (1982) "Judgement Under Uncertainty, Huristics and Biases", CUP.
Dr Mark Tomsett
Originally credited to Norman Lamont in a 1991 recession era speech at the Conservative Party conference, the phrase "green shoots" has been popping up everywhere recently. It even has it's own entry in the Cambridge Online Dictionary:
"Green Shoots - plural noun. (Used especially in newspapers) the firstsigns of an improvement in an economy that is performing badly."
From Baroness Vadera (who probably wishes she hadn't) to Ben Bernanke, from bank research articles to every newspaper whether pink or red topped (although the latter may have been referring to England's latest goalkeeper). However, as the burning sun torches the greenery in my garden so the "green shoots" appear to be withering. But rather than ask whether there ever were any green shoots, the more interesting question is how does the use of language and data affect our behaviour?
Social psychologists such as Kahneman, Slovic and Tversky (1) have studied how we make judgements under conditions of uncertainty. If you ask someone how likely it is that an elephant will fall out of the sky and land on their head they will tell you that the probability is (virtually) zero. Ask them again just after a five tonne African bull elephant has given them a fine centre parting (assuming they survive) and the their answer will be very different. Lotteries don't emphasise the fact that the odds of winning are tiny - they highlight the size of the payouts of recent winners.
These are just two examples of the so called "availability error" - the process of determining probability by the first thing that comes to mind. The "anchoring heuristic" describes how we determine the frequency, probability, or value of items by comparing the item to an anchor point. It appears to be relatively easy to influence the actions of individuals simply by generating numbers regardless of whether they have any relation to reality. Make the number dramatic enough and people will sit up and take notice. By the time people realise how baseless the original assertion was it's too late - it now has momentum. Ask someone (who doesn't actually know) to estimate the population of the Maldives and preface the question by asking whether it is more or less than one million. The actual number is much less but the average guess will be around this figure - the anchor point. Financial numbers can be manipulated in the same way. Unrealistic price targets, growth forecasts, etc, can easily become anchors. If the true figure turns out to be very different the market reaction can be severe even thoughthe original forecast should simply have been discounted more heavily.The problems caused by the "anchoring heuristic" can be exacerbated by the "confirmation bias". This is a tendency to find data that supports an hypothesis and ignore data that rejects it.
If you believe that a particular stock rises on a certain phase of the moon you'll make note of the rises when this phase occurs and ignore rises at other times. Doing this frequently reinforces the belief in this relationship.
These heuristics exist because they save us time. Why bother doing the research when a simple rule-of-thumb will suffice? However, failing to acknowledge their clear weaknesses can easily lead to irrational investment decisions. When someone starts talking of "green shoots" or any other phrase du jour look before you leap. Question their motivation and check to see if the supporting data stacks up. As the old saying goes, invest in haste and repent at leisure.
(1) Kahneman, D. Slovic, P and Tverskty, A. eds. (1982) "Judgement Under Uncertainty, Huristics and Biases", CUP.
Dr Mark Tomsett
Sunday, June 28, 2009
Inflating a golden balloon??
Hi,
A topic LINKS has seen in the press on and off in recent months has been the issue of whether Gold makes a good hedge against inflation. This issue clearly isn't the only one turning the grey matter of investors who have inflation issues.
Where are interest rates going? Can markets absorb the large supply and what will happen to inflation outright? Will governments use inflation to reduce the real impact of the huge wave of public expenditure of the last few months? At this stage it's unclear what will happen and it is this uncertainty that continues to drive markets.
It is unlikely that we will see inflation rear its head for some time while there is spare capacity in the global economy. However, those with a longer -term view or those looking at the tail risk should now be considering suitable hedges.
The obvious hedge for inflation is gold. Or is it? It's a position that has reached almost mythical status but supporting evidence is thin on the ground. In fact, the seminal work by Roy W. Jastram (1977) presented in "The Golden Constant" suggests something very different. He analyses the purchasing power of gold in England and the US from 1560 to 1976. The key conclusions are that:
- Gold is an ineffective hedge against inflation
- Gold appreciates in operational wealth in major deflations
- Gold is an ineffective hedge against yearly commodity price increases
- Gold maintains its purchasing power over long periods of time. This is not because gold eventually moves towards commodity prices but because commodity prices move towards gold.
The use of gold as an inflation hedge seems to have its roots in the collapse of the Bretton Woods agreement in 1971. Since gold was no longer regarded as money it would act like any other commodity. However, during Jastram's period of study gold flips between being "money" and a "commodity" on numerous occasions: it isn't this distinction that drives the relationship. Gold may not be money but it certainly acts like it. Gold is produced for accumulation, whereas all other commodities are produced for consumption.
The other reason for the strength of the hedgers' convictions is simply poor inductive reasoning. Because gold has preserved its value in periods of big upheaval does not mean that it is useful as a strategy against cyclical behaviour. It is a crisis hedge rather than an inflation hedge.
Those wishing to hedge inflation will need to be a little more creative, particularly given uncertainty over what will cause it and the point of its emergence. Something we will return to in a later blog.
Regards,
Dr Mark Tomsett
A topic LINKS has seen in the press on and off in recent months has been the issue of whether Gold makes a good hedge against inflation. This issue clearly isn't the only one turning the grey matter of investors who have inflation issues.
Where are interest rates going? Can markets absorb the large supply and what will happen to inflation outright? Will governments use inflation to reduce the real impact of the huge wave of public expenditure of the last few months? At this stage it's unclear what will happen and it is this uncertainty that continues to drive markets.
It is unlikely that we will see inflation rear its head for some time while there is spare capacity in the global economy. However, those with a longer -term view or those looking at the tail risk should now be considering suitable hedges.
The obvious hedge for inflation is gold. Or is it? It's a position that has reached almost mythical status but supporting evidence is thin on the ground. In fact, the seminal work by Roy W. Jastram (1977) presented in "The Golden Constant" suggests something very different. He analyses the purchasing power of gold in England and the US from 1560 to 1976. The key conclusions are that:
- Gold is an ineffective hedge against inflation
- Gold appreciates in operational wealth in major deflations
- Gold is an ineffective hedge against yearly commodity price increases
- Gold maintains its purchasing power over long periods of time. This is not because gold eventually moves towards commodity prices but because commodity prices move towards gold.
The use of gold as an inflation hedge seems to have its roots in the collapse of the Bretton Woods agreement in 1971. Since gold was no longer regarded as money it would act like any other commodity. However, during Jastram's period of study gold flips between being "money" and a "commodity" on numerous occasions: it isn't this distinction that drives the relationship. Gold may not be money but it certainly acts like it. Gold is produced for accumulation, whereas all other commodities are produced for consumption.
The other reason for the strength of the hedgers' convictions is simply poor inductive reasoning. Because gold has preserved its value in periods of big upheaval does not mean that it is useful as a strategy against cyclical behaviour. It is a crisis hedge rather than an inflation hedge.
Those wishing to hedge inflation will need to be a little more creative, particularly given uncertainty over what will cause it and the point of its emergence. Something we will return to in a later blog.
Regards,
Dr Mark Tomsett
Subscribe to:
Comments (Atom)