OIS discounting has become fundamental to nearly all risk neutral derivative pricing methods. Because OIS is the standard funding rate in CSA agreements in both the OTC and cleared markets, implications of not adopting best practices are significant.
The reality is that without accurate OIS curve construction, pricing, valuation and risk output are compromised. Inaccurate curve models can falsely suggest that an opportunity is mispriced in the market. Good trading opportunities may seem bad, and bad opportunities appear good, causing confusion and worse, costing you time and money.
OIS discounting has become even more important since the credit crisis sparked the migration of a massive number of derivatives from the OTC market to the exchanges, as investors attempted to mitigate counterparty credit exposure. A clear takeaway from the global financial crises was that many deals and institutions were severely under collateralized. In part, this lack of collateral spawned mistrust and an eventual freezing of certain markets.
Learning from these lessons we are now seeing an unprecedented increase in demand for collateral, particularly in the area of OTC derivatives. With the push towards full collateralization of derivatives portfolios, the number of derivatives that depend on OIS discounting has risen exponentially. At the same time, even OTC derivatives that aren’t fully collateralized depend on OIS discounting to calculate the base risk-free NPV with subsequent xVAs to be applied.
Today, many curve building frameworks have been updated to correctly handle OIS discounting, however many inaccuracies still arise. In our popular eBook, Advanced OIS Curve-Building: Best Practices, we look at some of the historical challenges posed by older curve building frameworks and then shift our attention to what we call 3rd Generation Frameworks. This framework introduces two innovations: it's future-proof to modeling changes and it answers the question: “What is calibration?” To answer this question, the framework separates the calibration into two parts: a Source and a Target. The Target is the function that must be changed in order to be consistent with the Source. The Source and Target method can be applied to any kind of calibration and, because it doesn’t include hard-coded simplifications or assumptions, it’s future-proof.
Use of the 3rd Generation Framework is quickly becoming an industry best practice for OIS curve building. Best-in-class solutions like FINCAD F3 utilize this approach, helping you move to market more quickly, generate pricing you can trust, and achieve a meaningful view of risk across the enterprise—among other advantages.
Interested in learning more best practices for building and using OIS curves for pricing, valuation and risk management of multi-asset, multi-currency portfolios? Download our eBook for more useful insight.