OIS discounting

Swap valuation with OIS discounting

OIS-discounting (from Overnight Indexed Swap)
is a derivatives valuation method considering multiple curves (and not one as before) for discounting and for projecting future cash flows.It’s used for collateralized derivatives.

CSA (Credit Support Annex)
its a contract (read “credit support”=collateral) which defines collateral management between counterparties of the contract. OIS discounting is the same as CSA-discounting.

Derivatives Valuation Changes

After the credit crunch of 2008 euribor rates cannot be considered as risk-free , because of the substantial spread between EONIA and Euribor swap (it used to be few bp before)
So, more and more swaps are getting collateralized now , and the interest rate which is paid on collateral is generally EONIA rate (for EUR cash collateral, for USD cash collateral it would be Fed Funds rate).
Because of this , the cashflows of the derivative should also be discounted with corresponding OIS rate.
from 2010 on LCH.Clearnet (major interest rate swap clearing house) has adopted its valuation method to OIS discounting.

Why negotiate swaps with collateral?
Dodd Frank act in the US and EMIR in Europe require that all eligible swaps be collateralized. In the same line BASEL III creates incentives for financial institutions to collateralize swaps (they would need less regulatory capital)

example

lets take a 5 year fixed-floating swap 100 euros notional , with 5% (out of the market) fixed rate and floating rate Euribor 6m (MTM of the swap about 19 euros)
with old method future cashflows are discounted and projected using the same euribor6m-based curve.
with OIS-discounting the cashflows are discounted using EONIA curve and projected using euribor6m-based curve(adjusted for EONIA discounting, which would slightly change the forward euribor rates)
difference between old and OIS discounting would be around 20 cents.

for at he market swaps the difference would be 0.
[calculations for sept 2012]

Deployment

In order to change to OIS-discounting one needs to make changes in legacy derivatives valuation systems – Front Office, Middle office , risk management, and collateral management systems.basic change is to introduce multiple curves for pricing and relevant changes for forward curves constructions.

difficulties in implementation

In the actual CSA (credit support annex) has many optionalities for both parties to post collateral (for example different currencies, different thresholds) which makes that every contract is unique.
The optionality for posting collateral in different currencies makes it a quanto product.Also some currencies still don’t have a liquid OIS-based swaps.

What is a financial impact?

several big banks has already published financial impact of OIS-discounting. bnp paribas has registered negatives impact of 108 millions EUR (2011),
crédit agricole 120 millions ,while some other banks have registered positive impacts , like Morgan stanley +176 M$ (2010),similar impact on RBS.
The sign of impact depends on the direction of the swap book of the institution.
MTM impact is material for legacy ,off-market , and forward starting swaps.
As a consequence it quite affects asset-swaps with euribor leg.

instruments:

apart from vanilla swap effect is big on instruments with euribor leg (this leg must be revalued).it also introduces dependance on EUrobor-EOnia spread to instruments which only were dependent on Euribor rates.
In general the difference is proportional on EONIA-euribor spread.
apart from the banks there is a big impact on insurers which have highly directional books