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