Raffaele Giura
Banca IMI - Risk Trading Fixed Income raffaele.giura@bancaimi.com
Raffaele Giura Interest rate yield curves before and after the crisis
should be equivalent to
and reinvesting the proceeds at the 3X6 forward rate.. ..otherwise arbitrage opportunities can exist in the market place
Raffaele Giura Interest rate yield curves before and after the crisis
Rates
0X3
3X6
Rate
0X6
Raffaele Giura Interest rate yield curves before and after the crisis
Raffaele Giura Interest rate yield curves before and after the crisis
Raffaele Giura Interest rate yield curves before and after the crisis
3X6 F.R.A. in the market was not actually priced from the 3m and 6m Euribors This difference was explicitely priced in the single currency basis swap market
Raffaele Giura Interest rate yield curves before and after the crisis
Market prices of the 3m vs 6m euribor basis swap for the 1y and 10y maturities: 2004 - 2007
Raffaele Giura Interest rate yield curves before and after the crisis
Market prices of the 3m vs 6m euribor basis swap for the 1y and 10y maturities: 2006 - 2010
Raffaele Giura Interest rate yield curves before and after the crisis
Pre-crisis framework
Raffaele Giura Interest rate yield curves before and after the crisis
Forwarding curves
Used only for computing the forward fixings implied in the market. Made from instruments with homogeneous underlying fixing
Discounting curves
Raffaele Giura Interest rate yield curves before and after the crisis
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Raffaele Giura Interest rate yield curves before and after the crisis
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3-Dec-2009
21-Jun2010
7-Jan-2011 26-Jul-2011
11-Feb2012
1,097,436
Raffaele Giura Interest rate yield curves before and after the crisis
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Euribor instruments
Discount factors
Forward fixings
We start from a set of market instrument with the same underlying euribor fixing We directly convert them in a discount factors We will compute the forward fixings we need from these discount factors It looks similar to the pre-crisis framework but it is more complex..
Raffaele Giura Interest rate yield curves before and after the crisis
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3X6
F.R.A.
0X6
0X6
6X12
.......
6X12
F.R.A.
12X18 disc. 6m 12m .....
........
Raffaele Giura Interest rate yield curves before and after the crisis
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F.R.A.
0X6
6X12
12X18
.......
Disc. factors
1m
6m
12m
18m
......
Pre-crisis: from a market quoted 1m maturity instrument! How do we compute the 1m disc. factor?
Raffaele Giura Interest rate yield curves before and after the crisis
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6m
7m
2 market instruments..
d1m
d6m d7m
Raffaele Giura Interest rate yield curves before and after the crisis
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1X7
7X13
7m
13m
Raffaele Giura Interest rate yield curves before and after the crisis
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Interpolation: important to run stress tests on the results. Constrained cubic spline on rate*time..
4.5 4 3.5 3 2.5 2 1.5 06-07-09
18-11-10
01-04-12
14-08-13
27-12-14
10-05-16
Raffaele Giura Interest rate yield curves before and after the crisis
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Interpolation: important to run stress tests on the results. Quartic spline on fwd-fwd rates..
4.5 4 3.5 3 2.5 2 1.5 06-07-09
!!
18-11-10
01-04-12
14-08-13
27-12-14
10-05-16
Raffaele Giura Interest rate yield curves before and after the crisis
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In examples so far we built the forwarding curve from market sets made only of F.R.A. When you put to zero F.R.As NPV you put to zero also their cashflows. This allowed us to ignore the discounting curve issue In real market conditions you have to include in the market set from which you build the curve also the I.R.S. Once you start using multicashflow I.R.S. discounting matters In practice you build the discounting curve first; then you find the forwarding curve that zeroes the NPVs of your set of at the money market instruments
Raffaele Giura Interest rate yield curves before and after the crisis
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Before the crisis discounting was based on the single Euribor curve The crisis implied that you have to use multiple curves. It wouldnt make sense to discount with a forwarding curve whose purpose is only to compute the forward fixings. You need something specific for discounting cashflows The crisis increased the awareness of the counterparty risk, so that on the interbank swap markets most of the new deals are now centrally cleared or at least protected by a CSA agreement.
Raffaele Giura Interest rate yield curves before and after the crisis
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CSA discounting
The discounting rate for the cashflows of a collateralized deal has to be computed keeping in account the CSA features. You can have: Standard CSA, that means: daily NPV calculations; daily margin calls; cash only collateral, in the same currency in which the deal is denominated, yielding the overnight rate. Market consensus is Eonia discounting here for EUR deals. Non standard CSA, that means: collateral delivery options, collateral paid in currencies different from the one in which the deal is written, margin call thresholds, asymmetrical collateral and in general any feature different from the standard CSA. Here specific discounting functions have to be built
Raffaele Giura Interest rate yield curves before and after the crisis
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LCH-Swapclear discounting
Nowadays most players in the EUR I.R.S. market are clearing their new deals in Swapclear. This means that the I.R.S. prices seen in the broker pages are meant to be good for counterparties that are clearing in Swapclear Swapclear variation margin system works in a way comparable with a standard collateral. This allows you to discount the cashflows of the EUR deals cleared in Swapclear at Eonia
Raffaele Giura Interest rate yield curves before and after the crisis
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LCH-Swapclear regulation
11.7 Price Alignment Interest The Clearing House collects and distributes changes in the net present value (NPV) of trades registered with it on a daily basis () The Clearing House (...) distributes PAI on cumulative variation margin received from an SCM. The PAI rate for Sterling is SONIA (Sterling Overnight Index Average); for Euro is EONIA (Euro Overnight Index Average); for USD is FEDFUNDS1; for YEN is TONAR, for Swiss Francs is TOIS, and for Danish, Norwegian Krone and Swedish Krona, Australian, Hong Kong, New Zealand and Canadian Dollars, Polish Zloty and South African Rand, the appropriate overnight input into our end-of-day yield curves is used.
Raffaele Giura Interest rate yield curves before and after the crisis
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Raffaele Giura Interest rate yield curves before and after the crisis
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The Eonia curve building: practical advantages vs Euribor curve building after the crisis (1)
When you consider the Eonia swap market you can still correctly compute the 3X6m forward rate from the 3m and 6m spot rates.There is no 3m vs 6m basis as in the Euribor swap market.
0X3m Eonia swap 3X6m Eonia swap
Raffaele Giura Interest rate yield curves before and after the crisis
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The Eonia curve building: practical advantages vs Euribor curve building after the crisis (2)
When we build the Eonia forwarding curve we do not have to fill in the in between discount factors in an arbitrary way, as we did on the Euribor curve. We can compute them directly from market quoted instruments (the 1m discount from the 1m Eonia rate) Lastly if we are also discounting at Eonia (which Ill assume we are doing from now on) we will have the same curve used both for forwarding and discounting: in other worlds the Eonia swaps can still be priced correctly with the old single curve framework (even if the eonia curve bootstrapping has its own specific features)
Raffaele Giura Interest rate yield curves before and after the crisis
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0m
1m 1X4m F.R.A.
4m
0m 1m
4m
Raffaele Giura Interest rate yield curves before and after the crisis
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Raffaele Giura Interest rate yield curves before and after the crisis
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0 .3 0 .2 5 0 .2 0 .1 5 0 .1 0 .0 5 0
06- Ju l- 0 9 18- Nov - 1 0 0 1- A pr - 1 2 14 - A ug - 13 2 7- Dec - 14 10 - May - 1 6 22- Se p- 1 7 04 - Feb- 1 9 1 8- Jun- 20 31 - Oc t- 21
Raffaele Giura Interest rate yield curves before and after the crisis
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0 .3
Euribor fixings
0 .2 5 0 .2 0 .1 5 0 .1 0 .0 5 0
0 6 - Ju l- 0 9 1 8 - No v - 1 0 01-A pr-12 14-A ug-13 2 7 - De c - 1 4 1 0 - Ma y - 1 6 22-Sep-17 0 4 - Fe b - 1 9 1 8 - Ju n - 2 0 3 1 - O c t- 2 1
Raffaele Giura Interest rate yield curves before and after the crisis
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Eonia + spread needs a developed Eonia swap market extended to long and extra long maturitites: you can not apply this kind of solution to all currencies. However, if you discount at Eonia equivalent rates, you will need an Eonia curve anyway In real life curve calibration can be more difficult, mainly in market stress situations Eonia + spread solution is likely to require more work to implement it in the pricing, risk and revaluation systems
Raffaele Giura Interest rate yield curves before and after the crisis
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On the other side if you use Eonia + spread you do not have to rely on values of the in between discount factors which are at the end filled in by an arbitrary way Eonia + spread could allow you to extract more informations from the yield curve. You have two different term structures, each one doing a different job. From the Eonia curve term structure you can extract informations on how interest rates are expected to evolve in the future; from the Euribor-Eonia term structure you can extract informations on the way the banking sector stress is expected to evolve in the future
Raffaele Giura Interest rate yield curves before and after the crisis
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If needed slides
Raffaele Giura Interest rate yield curves before and after the crisis
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Day 1, at 12.00: IRS trader pays 1 bn 10y swap vs Euribor 6m at 3.32 to counterparty Day 1, at 17.15: close of business: -10y vs 6m swap rate went up -swap NPV now = 9 mn euro -counterparty will post (give us) 9mn eur as collateral
Raffaele Giura Interest rate yield curves before and after the crisis
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Day 2, at 17.15: close of business -no new deal has been made -market moved: swap NPV is now = 10mn -counterparty should pay us 1mn ( 10mn 9mn = NPV(day2)-NPV(day1) -we should pay to the counterparty the 1 day interests on the 9 mn we received yesterday; the rate of interest we use for this calculation is the CSA rate; if we agreed to use the overnight as CSA rate, and the overnight was 1.25% we have to pay 312.5 eur (9mn * 1.25% / 360) -net payment: we rec 999.687,5 eur
Raffaele Giura Interest rate yield curves before and after the crisis
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http://www.wilmott.com/messageview.cfm?catid=4&threadid =68959&FTVAR_MSGDBTABLE=
Raffaele Giura Interest rate yield curves before and after the crisis
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Why we should discount the cashflows of the collateralized deals with the CSA rate? Test explanation
Raffaele Giura Interest rate yield curves before and after the crisis
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NPV
days 0X1 1X2 2x3 3x4 4x5 5x6 6x7 7x8 n x n+1.. Disc. rates
Raffaele Giura Interest rate yield curves before and after the crisis
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