Derivatives: valuation challenges...Barclays Bank plc HSBC France Caixa Geral De Depósitos (CGD) Mizuho Bank, Ltd. Natixis Banco Bilbao Vizcaya Argentaria - Banco Santander Citibank

Derivatives: valuation challengesEurobanking 2017Slovenia, May 29, 2017

© 2017 Deloitte The Netherlands

Nick van Pelt – Junior Manager

Background• MSc. Quantitative Finance, EUR• BSc. Econometrics & Operations Research, EUR• BA, History, EUR• Certified Financial Risk Manager (FRM), GARP

Contact InformationE-mail: [email protected]

Who am I?

1


Derivatives: valuation challenges

• Introduction

• Discussion

• Interest rates

• Interest rate swaps: pre-crisis

• Interest rate swaps: post-crisis

• Value adjustments

• Central clearing: MVA

Agenda

2


Introduction

3


Characteristics

• A derivative is an instrument whose value depends on, or is derived from, the value of another underlying.

• Examples: futures, forwards, swaps, options, exotics…

• The underlyings include for example stock prices, currencies, interest rates, commodities, inflation, temperature, credit worthiness, etcetera.

• Derivatives play a key role in transferring risks in the economy.

• Derivatives are traded on the exchange or in the over-the-counter (OTC) market where traders working for banks, fund managers and corporate treasurers contact each other directly.

What is a derivative?

4


Theory

• Pricing and valuation of derivatives is often quite simple… in theory.

Pricing and valuation of derivatives

5

• Share prices follow a Geometric Brownian Motion with constant mean andvolatility

• Short selling of stocks is allowed

• No transaction costs

• No taxes

• All securities are infinitely divisible

• There are no arbitrage opportunities

• Continuous trading

• It is possible to borrow and lend cash at a constant risk-free rate


Reality

• But in reality…

Pricing and valuation of derivatives

6

“One way of ensuring that you fully understand a financial instrument is to value it. If a corporation does not have the in-house capability to value an instrument, it should not trade it.” © John C. Hull


Looking at derivatives from different angles

Environment

7


Looking at derivatives from different angles

Environment

8


Discussion

9


Introduction

“True or false: hedging with derivatives always introduces risk.”

Derivatives

10

Hedge or not hedge?


Introduction

“Why has the outstanding notionals and market values of derivatives in the over-the-counter market declined substantially over the past few years?”

Derivatives

11

Amounts outstanding notionals of over-the-counter (OTC) derivatives

Contract

types

Notional amount outstanding (billion USD) (Gross) market values (billion USD)

2012 2013 2014 2015 2012 2013 2014 2015

Foreign

exchange67,358 70,553 75,043 70,446 2,313 2,284 2,936 2,579

Interest

Rate492,605 584,799 505,431 384,025 19,038 14,200 15,586 10,148

Equity

linked6,251 6,560 6,968 7,141 600 700 612 495

CDS 25,068 21,020 16,399 12,294 848 653 593 421

Other 41,815 25,496 22,541 17,685 1,808 724 802 558

Total 635,685 710,633 628,251 492,911 24,953 18,825 20,847 14,498


Introduction

“True or false: the importance of value adjustments in pricing and valuation of derivatives is increasing.”

Derivatives

12


Interest rates

Types of interest rates

13


Which rate would you consider most risk-free?

Which rate would you consider most risk-free?

A. London interbank offered rate (LIBOR)

B. Euro interbank offered rate (EURIBOR)

C. Euro OverNight Index Average (EONIA)

D. (Overnight) repo rate

E. Other rate?

And why is a proxy for the risk-free interest rate important for derivatives…?

Risk-free rate

14


LIBOR

• The London interbank offered rate or LIBOR, is viewed as the cost banks pay to borrow funds from other banks in the interbank market.

• It gives an indication of the average rate a leading bank, for a given currency, can obtain unsecured funding for a given period in a given currency.

• The currencies are the British pound sterling, US dollar, Euro, Japanese yen and the Swiss frank.

• It is compiled each day by ICE Benchmark Administration Limited, for maturities ranging from overnight to 12 months.


15


EURIBOR

• The Euro interbank offered rate or EURIBOR, is the rate at which euro interbank depositsare offered between banks and is compiled by European Money Markets Institute (EMMI).

• The bank panels are determined using several criteria. Since these criteria differ between the EURIBOR and LIBOR, the rates also are not similar.

• LIBOR is mainly based on prime banks, whereas EURIBOR banks are banks with the highest volume of business in the Eurozone, which results in a panel with also Greek and Spanish banks. These panels are shown on the next slide.


16


LIBOR and EURIBOR banking panels


17

ICE EUR LIBOR panel EMMI EURIBOR panel

Lloyds TSB Bank plc Belfius Banque et Caisse d'Épargne de l'État

Bank of Tokyo-Mitsubishi UFJ Ltd BNP-Paribas ING Bank

Barclays Bank plc HSBC France Caixa Geral De Depósitos (CGD)

Mizuho Bank, Ltd. Natixis

Banco Bilbao Vizcaya Argentaria - Banco

Santander

Citibank N.A. (London Branch) Crédit Agricole s.a. CECABANK

Coöperatieve Rabobank U.A.

Société Générale

Deutsche Bank CaixaBank S.A.

Credit Suisse AG (London Branch) DZ Bank Barclays

Royal Bank of Canada National Bank of Greece London Branch of JP Morgan Chase Bank N.A.

HSBC Bank plc Intesa Sanpaolo

Santander UK Plc Monte dei Paschi di Siena

Deutsche Bank AG (London Branch) UniCredit

JPMorgan Chase Bank, N.A. London Branch

Société Générale (London Branch)

The Royal Bank of Scotland plc

UBS AG


The Fed Funds Rate

• Unsecured interbank overnight rate of interest

• Allows banks to adjust the cash (i.e., reserves) on deposit with the Federal Reserve at the end of each day

• The effective fed funds rate is the average rate on brokered transactions

• The central bank may intervene with its own transactions to raise or lower the rate


18


EONIA

• The Euro OverNight Index Average or EONIA is the effective overnight reference rate for the euro. It is computed as a weighted average of all overnight unsecured lending transactions undertaken in the interbank market, initiated within the euro area by the contributing banks.

• EONIA is compiled with the help of the ECB with information from the same set of panel banks as for EURIBOR. But, whereas EURIBOR has different maturities, the EONIA is only for overnight.


19


Repo rate

• Repurchase agreement is an agreement where a financial institution that owns securities agrees to sell them for X and buy them back in the future (usually the next day) for a slightly higher price, Y

• The financial institution obtains a loan.

• The rate of interest is calculated from the difference between X and Y and is known as the repo rate


20


Interest rate swaps

Pre-crisis

21


Notionals and market values

Amounts outstanding of OTC derivatives

22


Contract

types


2012 2013 2014 2015 2012 2013 2014 2015

Foreign

exchange67,358 70,553 75,043 70,446 2,313 2,284 2,936 2,579

Interest

Rate492,605 584,799 505,431 384,025 19,038 14,200 15,586 10,148

Equity

linked6,251 6,560 6,968 7,141 600 700 612 495

CDS 25,068 21,020 16,399 12,294 848 653 593 421

Other 41,815 25,496 22,541 17,685 1,808 724 802 558

Total 635,685 710,633 628,251 492,911 24,953 18,825 20,847 14,498


Nearly 60% of total value OTC derivative market consists of interest rate swaps


23


Contract

types


2012 2013 2014 2015 2012 2013 2014 2015

Forward

rate

agreements

71,960 78,810 80,818 58,326 48 108 145 114

Swaps 372,293 456,725 381,129 288,634 17,285 12,919 13,925 8,993

Options 48,351 49,264 43,484 37,065 1,706 1,174 1,516 1,042

Total 492,605 584,799 505,431 384,025 19,038 14,200 15,586 10,148


Hedging using an interest rate swap

Characteristics interest rate swaps

24

• An interest rate swap (IRS) is an agreement to exchange interest rate cash flows, calculated on a notional principal, at specified intervals (“settlement dates”) during the life of the agreement. Each party’s payment obligation is computed using a different interest rate.

• In the simplest and most common interest rate swap, a plain vanilla swap, typically refers to a generic interest rate swap in which one party pays a fixed rate and one party pays a floating rate.

Company

Bank B

Bank A

Fixed Ratex Notional Swap

Floating Ratex Notional Swap

Floating Ratex Notional Loan

LoanAgreement

IRS


Trade, effective, termination and settlement dates

Interest rate swap

25

• The trade date is the date on which the parties agree the terms of a contract.

• The effective date is the date on which the parties begin calculating accrued obligations, such as fixed and floating interest payment obligations on an interest rate swap.

• The termination date (often called maturity date) is the date on which obligations no longer accrue and the final payment occurs.

• The term of a transaction lasts from the effective date to the termination date.

• The settlement date is the date at which the payments are made.

• The business day convention states how payments on non-business days are treated


OIS

Interest rate swap

26

• An Overnight Indexed Swap or OIS is an interest rate swap, where the floating rate is tied to a published overnight rate index. In the Eurozone this is EONIA, in the United States it is the Federal Funds rate.

• The floating rate cash flow is the interest accrued from the geometric average of the floating overnight index on the agreed upon notional.

• The accrual of the floating leg of the swap is identical to that of a strategy in which one borrows cash in the amount of the swap’s notional principal, invests in the overnight index rate and repeats the transaction, investing principal plus interest on an overnight basis

• The parties agree to exchange the difference between the fixed rate cash flow and the floating rate cash flow at the payment date.


Determine the value of an interest rate swap

Pre-crisis valuation interest rate swap

27

Mark-to-market value interest rate swap

• The net present value of all (‘expected’) incoming and outgoing cash flows.

Forecasting curve

• Curve that is used to compute forward rates (which determine payments floating leg).

• Forward rates are needed since we don’t know what the floating rate will be, say, 2 years form now.

• The curve is constructed according to tenor of the floating leg.

Discounting curve

• Curve that is used to discount the future cash flows.


Bootstrapping

Valuation interest rate swap

28

• The cash rates, FRA rates and swap rates are par rates, these need to be converted to zero rates.

• Zero rates are rates for which the interest and principal payments are made at maturity of the instrument, hence no intermediate payments.

• At the short end of the curve, some instruments have a par rate that equals the zero rate, in this case the instrument makes no intermediate payments.

• Bootstrapping is this process of converting the par rates into zero rates.


Small spreads and limited spread volatility (EUR swap curves, January 4, 2007)

Market developments

29

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

1Y 2Y 3Y 4Y 5Y 6Y 7Y 8Y 9Y 10Y11Y12Y15Y20Y25Y30Y35Y40Y45Y50Y

S45 Euro Swaps Curve S201 Euro (vs. 3M Euribor) Curve

S232 Euro (vs. 1M Euribor) Swap Curve S133 Eonia Curve


Pre-crisis – traditional – single-curve valuation of IRS


30

Single curve approach

1. Define the set of vanilla instruments (cash rates, future/forward rates, swap rates) and algorithms to be used to construct ‘the swap curve’.

2. Calculate the discount factors from ‘the swap curve’ derived in step 1.

3. Calculate the forward rates using the discount factors derived in step 2.

4. Calculate the expected cash flows of the swap contract under the assumption that the floating rates equal the forward rates calculated in step 3.

5. Calculate the value of the swap contract by discounting the swap cash flows derived in step 4 using the discount factors derived in step 2.


Interest rate swaps

Post-crisis

31


The crisis


32


Small spreads and limited spread volatility (EUR swap curves, January 4, 2007)

Market developments

33

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

1Y 2Y 3Y 4Y 5Y 6Y 7Y 8Y 9Y 10Y11Y12Y15Y20Y25Y30Y35Y40Y45Y50Y


S232 Euro (vs. 1M Euribor) Swap Curve S133 Eonia Curve


The day Lehman collapsed (EUR swap curves, September 15, 2008)

Market developments

34

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

1W 1M 3M 5M 7M 9M 11M15M21M30M 4Y 6Y 8Y 10Y 12Y 20Y 30Y 40Y 50Y

S232 Euro (vs. 1M Euribor) Swap Curve S201 Euro (vs 3M Euribor) Curve

S45 Euro Swaps Curve S133 Eonia Curve


The (confidence) crisis

Market developments

35

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

Mar-05 Jul-06 Dec-07 Apr-09 Sep-10 Jan-12 May-13 Oct-14 Feb-16

EURIBOR 3M minus EONIA 3M

BNP Paribas announces credit

difficulties, suspends

redemptions from three

money market funds, because of

valuation difficulties in

subprime assets.(August 8, 2007)

Collapse of Lehman Brothers(September 15, 2008)

Moody’s downgrades Portugal by 4 notches from Baa1 to junk status Ba2


The (confidence) crisis

Market developments

36

0.0%

0.1%

0.2%

0.3%

0.4%

0.5%

0.6%

0.7%

Mar-05 Jul-06 Dec-07 Apr-09 Sep-10 Jan-12 May-13 Oct-14 Feb-16

10Y EUR SWAP minus 10Y EONIA


Cross-currency basis spreads between EUR and USD

Market developments

37

-0.6%

-0.5%

-0.4%

-0.3%

-0.2%

-0.1%

0.0%

0.1%

Nov-04 Nov-06 Dec-08 Jan-11 Jan-13 Feb-15 Mar-17


Current market (EUR swap curve)

Market developments

38

-0.6%

-0.4%

-0.2%

0.0%

0.2%

0.4%

0.6%

0.8%

1.0%

1.2%

1.4%

0 2 4 6 8 10 12 14 16


S232 Euro (vs. 1M Euribor Swap Curve) S133 EONIA Curve


Multicurve approach with cash collateral earning the overnight rate

Post-crisis – current – valuation of IRS

39

1. Define the set of instruments and algorithms to be used to construct the swap curve (tenor curve).

2. Define the set of instruments and algorithms to be used to construct the OIS curve (discounting curve).

3. Calculate the discount factors from the OIS curve derived in step 2.

4. Calculate forward rates using the swap (tenor) curve from step 1 using the discount factors derived in step 3.

5. Calculate the expected cash flows of the swap contract under the assumption that the floating rates equal the forward rates calculated in step 4.

6. Calculate the value of the swap contract by discounting the swap cash flows derived in step 5 using the discount factors derived in step 3.

Please note: The cash flows in step 6 are discounted using ‘OIS’ discount factors as the collateral is assumed to earn the overnight rate. The collateral agreement determines the discount factors to be used for discounting the ‘expected’ cash flows in step 6.


Summary swap pricing

40Insert your footer here


Value adjustments

41


Or the price?

The value of a derivative

42

“What is the difference between the price and the value of a derivative?”


Mark-to-market value

43

“True or false: the value of a derivative equals the mark-to-marketvalue of the derivative.”

“True or false: the value of a derivative equals the accounting value of the derivative.”


XVAs

Other valuation drivers

44

Pre-crisis valuation

Tenor curve

Post-crisis valuation

Tenor curve Overnight

Index Swap

(OIS) curve

Credit Value

Adjustment

(CVA)

Funding

Benefit

Adjustment

(FBA)

Collateral

implied

curve

Debt Value

Adjustment

(DVA)

Funding

Cost

Adjustment

(FCA)

Replacemen

t Value

Adjustment

(RVA).

Collateral

Value

Adjustment

(ColVA).

Capital

Value

Adjustment

(KVA).

Margin

Value

Adjustment

(MVA).

Break

clauses

(termination

amount)


Recent developments

• Several years ago, major dealers started to centralize the management and hedging of their derivatives valuation adjustments with dedicated XVA desks, introducing 'XVA optimization‘.

• Dealers earn millions by transferring client trades through novations to other parties with different risk offsets, funding costs, regulatory capital regimes or credit spreads.

• XVAs play a large role in the costs of derivative trading. Parties who neglect the impact on their books are losing out…

Impact XVA’s on use derivatives

45


Credit Valuation Adjustment (CVA)

Counterparty credit risk (CCR)

46

IFRS 13 states that the likelihood of counterparty default must be included in assessing hedge effectiveness: CVA and DVA.

CVA and DVA are applicable for uncollateralized swaps.


• CVA represents the difference in value between a completely risk-free value and a value that takes the possibility of counterparty default into account.

• It can be defined as the present value of expected loss due to counterparty default.




47

CVA is calculated by taking the expected positive exposure (EPE) and multiplying this by the counterparty’s default rate (PD) and the loss given default (LGD):

• E.g. Interest rate swaps exchange multiple cashflows

𝐶𝑉𝐴 = 1 − 𝑅 ×

𝑡=0

𝑇

𝐷 𝑡 ∗ 𝐸𝑃𝐸 𝑡 ∗ 𝑃𝐷(𝑡)

Recovery Rate. (1 – R) = LGD

Probability of Default

Discounted Expected Exposure


Debt Value Adjustment (DVA)


48

Debit Valuation Adjustment (DVA)

• The DVA represents the difference in value between a completely risk-free value and a value that takes the possibility of a party’s own default into account (the entity’s own credit risk).

• Conversely to CVA, the DVA is the present value of counterparty’s expected loss due to our default. In other words, DVA is CVA seen from counterparty’s perspective.

• The inclusion of DVA in pricing is seen as somewhat necessary to allow for pricing symmetry.

• Accounting standards require it, whereas regulation does not recognize it.

Market value swap = Risk-free value swap – CVA + DVA


DVA

Debit value adjustment calculation

49

“How is this possible?”


DVA

Debit value adjustment calculation

50


Pricing in the presence of collateral agreements

51

• It is becoming increasingly common for transactions to be collateralizedin OTC markets

• Derivative transactions are regulated by an ISDA Master agreement with sometimes a credit support annex (CSA)

• The CSA regulates credit support for derivative transactions:

− Terms governing acceptable collateral focus on credit protection, but also fix cash reference rates and haircuts on other assets.

For example:

• Consider transactions between companies A and B

• The CSA might require A to post collateral with B equal to the value to B of its outstanding transactions with B when this value is positive for B.

• If A defaults, B is entitled to take possession of the collateral


Pricing in the presence of collateral agreements

52

• Margin requirements (variation margin, initial margin, etcetera)

• Minimum transfer amount & type of collateral (incl. haircuts)

• Re-hypothecation, substitution, owner of return of collateral

• Frequency collateral calculations & margin calls

• Break clauses

• Market risks associated with (non-cash) collateral and derivatives


Funding value adjustment (FVA)

• Funding costs/benefits should be taken into account when collateralized derivative transactions are valued. This results in the Funding Value Adjustment (FVA).

• When a dealer is in-the-money on a trade, it receives collateral from its collateralized hedge counterparty, and if the collateral is assumed to be rehypothecable, the dealer should be able to lend that collateral to its treasury, which is a funding benefit. The results in the Funding Benefit Adjustment (FBA).

• When a dealer is out-of-the-money on a trade, it has to post collateral to its collateralized hedge counterparty, and would therefore need to borrow money from its internal treasury, which is a funding cost. The results in the Funding Cost Adjustment (FCA).

FVA = FBA – FCA

Funding costs/benefits

53


Impact of a derivative trade on capital requirements

Banks are required to hold three different types of capital under Basel III (CRD IV, CRR) for the risk of a derivative trade:

Market risk

Capital against market movements (i.e. interest rate risk capital for an interest rate swap) that change the market value of the derivative. This results in market risk capital in the trading book or the banking book

Counterparty credit risk

Capital for the risk that the client defaults and (part of) the current market value of the derivative is lost.

Credit value adjustment

Capital for the risk that the credit quality (e.g. credit rating, credit spread) of the client changes.

This results in value adjustments for the bank, the capital value adjustment (KVA).

This means that banks start pricing capital costs – KVA – into their derivatives trades.

Capital value adjustment (KVA)

54

0 1

0 2

0 3


Central clearing

55


Introduction

• A clearing house acts as an intermediary in futures transactions.

• It guarantees the performance of the parties to each transaction.

• The clearing house has a number of members.

• Brokers who are not members must channel their business through a member.

• The main task of the clearing house is to keep track of all the transaction that take place during a day, so that it an calculate the net position of each of its members.

Clearing houses

56


Margin account

Margin

• A margin is cash or marketable securities deposited by an investor with his or her broker.

• Margins minimize the possibility of a loss through a default on a contract.

Margin Account

• Investors maintain a margin account with a broker.

• Brokers maintain a margin account with a clearinghouse member.

• Clearinghouse members maintain a margin account with the clearing house.

• The balance in the margin account is adjusted to reflect daily settlement.

Margins

57


Initial, maintenance margin and variation margin

• Initial margin is the buffer applied in addition to the variation margin to cover unexpected losses that may occur during the close-out process in the case of a counterparty's default.

• Initial margin can often be in non cash collateral with a haircut applied.

• A trader has to bring the balance in the margin account up to the initial margin when it falls below the maintenance margin level.

• A clearing member of the exchange clearing house only has an initial margin and is required to bring the balance in its account up to that level every day. These daily margin cash flows are referred to as variation margin.

• A clearing member is also required to contribute to a default fund.

Margins

58


Central counterparty

• A central counterparty (CCP) is like an exchange clearing house.

− It stands between two parties to the derivative transaction so that one party does not have to bear the risk that the other party will default.

• Like members of an exchange clearing house, the members of a CCP provide initial margin, daily variation margin, and contributions to the default fund.

Clearing houses in OTC markets

59


From a bilateral model to the CCP model…

• Traditionally most transactions have been cleared bilaterally in OTC markets: each market participant has a legal relationship with, and separate (gross) exposure to each of the other participants, creating a tangled web of exposures.


60

A

F

B C

D

E

Weaknesses exhibited during the crisis

Counterparty credit risk

Possible systemic implications

that a default or fear of a default

can have due to the

interconnected web of market

participants.

Weak risk management

especially for bespoke

transactions, led to realised

losses in times of market stress.

Lack of transparency

Regulators did not have

sufficient oversight of global

positions to detect the

accumulation of pockets of risk

within the financial system.


From a bilateral model to the CCP model…

• Each market participant has a legal relationship with and (gross) exposure to the CCP only, regardless of the identity of their counterparty in the underlying trade.


61

Regulatory response

• All standardised derivatives should be centrally cleared.

• Non centrally cleared derivatives should be bilaterally collateralised and subject to higher capital requirements.

• All OTC derivatives should be reported to a TR.

• All standardised and sufficiently liquid OTC derivatives should be traded on an exchange or electronic trading platform.


CCP

“How would you calculate initial margin requirements?”

“TRUE OR FALSE: Different CCPs may charge different initial margins for similar trades”

“What impact would initial margin have on capital requirements?”

Discussion

62


MVA

• Posting initial margin has to be funded.

• Initial margin received can in most cases not be re-hypothecated.

• Hence, there are no funding advantages from initial margin requirements. This results in an important funding cost: the Margin Valuation Adjustment (MVA).

“Initial margin requirements reduce credit risk, but what type of risk does it introduce?”

Margin valuation adjustment

63


Conclusion

Impact XVA’s on use derivatives

64

• Cost of trading derivatives has implications for the valuation.

Value = MtM - CVA + DVA + FVA - KVA - MVA + … + …

• MtM = Mark-to-market value

• CVA/DVA = Credit Value Adjustment / Debit Value Adjustment

• FVA = Funding Value Adjustment

• KVA = Capital Value Adjustment

• MVA = Margin Value Adjustment

“What cross-relations do you observe for the value adjustments above?”

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Documents

Derivatives: valuation challenges...Barclays Bank plc HSBC France Caixa Geral De Depósitos (CGD) Mizuho Bank, Ltd. Natixis Banco Bilbao Vizcaya Argentaria - Banco Santander Citibank