OIS Curve and Implementation Issues
In the wake of the recent financial crisis and subsequent Dodd-Frank requirements, there has been an increased focus on risk and credit measurement in derivatives markets.
This has caused the market to transition from the use of traditional LIBOR towards using the OIS (Overnight Indexed Swap) curve for discounting derivative cash flows.
The OIS curve differs from the LIBOR curve in that it incorporates more robust measures of counterparty risk, and the role of collateral and central clearing, into the discount curve. The move to a two curve paradigm, as well as the contemplation of the additional risk parameters in portfolio valuations, will result in challenges both for the swap dealers and end-users. Some of the more significant implementation challenges are detailed below.
The greatest challenge regarding valuations is the lack of available market data. Active OIS curves exist for only 5 currencies. Although the curves may be quoted out to longer tenors, market liquidity is relatively deep only out to the five year term in most cases. This results in challenges in arriving at the correct OIS par rates for not only cross currency and more tailored derivatives, but even long dated vanilla trades. This is further compounded by the fact that legacy technology is not designed to handle multiple curves and requires additional adjustments to allow for OIS discounting.
Not all collateralized trades will be discounted using OIS. Swap participants will need to understand the nuances of the Credit Support Annexes and evaluate the nature of the collateral requirements. Factors such as type of collateral and liquidity of such collateral, unilateral vs. bilateral posting requirements etc. would impact which cash flows of a particular trade would be discounted using OIS.
As detailed above, end users will have to arrive at the correct valuations and evaluate the impact of collateral in line with market conventions. As a result of this, the discounting curve may differ across different instruments in the portfolio. There may be ‘Fair Value’ implications as well resulting from the lack of liquidity for longer OIS tenors. As a result of these factors, end users may have to meet additional disclosure requirements.
In addition, the transition from LIBOR to OIS curves may cause larger portfolio MTM changes resulting in greater income statement volatility. Challenges will also arise in assessing hedge effectiveness, especially as it relates to fair value hedging. There may be situations where the hedge, due to collateralization, uses OIS discounting but the hedged item continues to be valued based on LIBOR discounting. This could lead to increased ineffectiveness and a potential for failing to qualify as an effective hedge.
The market is still in a period of transition as all market participants continue to consider the implications of switching to OIS discounting. Market trading continues to move towards replacing LIBOR with OIS as the risk free curve for discounting, irrespective of trade collateralization, however the impact is still being evaluated. Over time we should begin to see greater market convergence on implementation, resulting in more defined guidelines regarding the issues discussed above.
For more information on the OIS curve and its implementation challenges, contact us.
Written by alexandra-loppnow