Point De Vue: Operational challenges faced by asset managers to price OTC derivatives Laurent Thuilier, SGSS. Avec le soutien de

Transcription

1 Point De Vue: Operational challenges faced by asset managers to price OTC derivatives Laurent Thuilier, SGSS Avec le soutien de

2 JJ Mois Année Operational challenges faced by asset managers to price OTC derivatives Investance Institute, january 2012 Laurent Thuillier Head of asset servicing

3 Agenda Introduction Impact of the financial crisis on valuations Independent Valuation : A step by step process Case Study Collateral Management : a new challenge 2

4 Introduction Why buy side has to focus on OTC derivative valuation? Complexity of OTC derivatives Financial crisis impact : Less liquidity mark to model methodology has to be implemented More price discrepancies with counterparties Need for independent valuation on OTC s and structured products: Independent valuation regulatory requirement : Luxembourg & France for instance Collateral management : challenging of counterparty s margin call Whatever it is done by the asset management company or by a third party provider the challenge of independent valuation has to be addressed 3

5 Introduction OTC s : A growing market 4

6 Introduction IR : Asset swap, IRS, CCS, FRA, Swaption, Inflation swap, Bond option Cap/Floor, Collar, Ascot FX: Fx fwd, Fx swap, FX option, NDF, NDO Credit : CDS, CDX, Synthetic CDO s, NtD Equity: Variance swap, Volatility Swap, TRS, ELS, Equity option, Equity basket swap, Equity basket forward, index option, Dividend swap Commodity: Swap, Options, swaption, index swap Structured products : hybrids, barriers, cliquet, callable, switchable, ratchet, snowball Securitised products : ABS, MBS, cash CDO s.. OTC s encompass a huge number of instrument types across all asset classes 5

7 Impact of the recent financial crisis on valuations April 2011 Edhec Alternative Investment Days 2011 Laurent Thuillier

8 Financial Crisis : Basis spread widening 10 Y Eur3M /Eur6M basis spread between 2004 and 2011 Lehman s fall Euro swap rate on Euribor with different tenors cannot be discounted anymore with the same curve Consequently many curves had to be built and maintain in the system for each currency 7

9 Financial Crisis : Equity volatility increase VIX index = short term expectation of volatility on S&P500 The fast-change in volatility forecast led to less robust calibration processes Lehman s fall More valuation discrepancies to analyse 8

10 Financial Crisis : IR volatility increase Move Index tracks the volatility of the Interest rate market Lehman s fall 9

11 10 1M Implied volatility on USD/KRW Financial Crisis : FX volatility increase Lehman s fall

12 11 5 Yr EUR/USD Basis Spread Financial Crisis : Cross-currency basis spread

13 12 Average 2 Yr implied dividends in EU Financial Crisis : Dividend dynamic More complex dynamic for dividends. Is it a new risk factor? Correlations between equities have increased as an anticipation of systemic risk. Is it a new risk factor?

14 Independent Valuation : A step by step process April 2011 Edhec Alternative Investment Days 2011 Laurent Thuillier

15 14 Valuation process Valuation Process : a four step process Instrument specification : payoffs, conditional cash flows, risk factors Market parameters management : acquisition and validation of market data Price calculation and sensitivities : models, numerical methods, calibration, IT framework : pricing libraries, grid computing Output control : benchmarking valuations / models, discrepancy analysis Associated risks Bad specification Market data unavailable or corrupted: «Garbage In, Garbage out» Model risk, «Overfitting», numerical error, technology failure No benchmark with counterpart's valuations

16 15 OTC s Valuation Process Trade characteristics Valuation Model Market data

17 16 Trade management Getting the trade in the system Can be automated for vanilla trades such as IRS, CDS or FX options Cannot be automated for structured/ bespoke products : the only reliable information is the term sheet Managing the product life-cycle Trade amendment Nominal increase / decrease / partial or full termination Fixing resetting Managing events Corporate action Trigger events (barriers..), exercises Credit event Life-cycle of OTC s is complex and has direct impact on the quality of the valuation function

18 Pricing Models Each asst class has its own dynamics Inflation needs seasonal adjustments Interest rates tend to exhibit mean-reverting behaviour Equity dynamic needs to take into account dividend forecasts For OTC vanilla Models are simple and used by all market participants Numerical methods : mainly closed formulas no numerical errors For Exotics and structured products Models can by fairly complex and sometimes no consensus from market participants Numerical methods are time consuming : MC simulations, PDE, Trees Numerical errors need to be monitored Models need to be calibrated Financial engineering expertise is required to develop and maintain those pricers 17

19 Market parameters Data Acquisition Usual providers for yield curves, fixings Consensus for dividends, CDS curves... OTC brokers for equity volatility or swaption cube Investment banks for exotic parameters such as correlation Multi-sourcing hierarchy management Data validation : cleaning / sanity check Complex data re-engineering Smoothing of volatility surface if the surface is arbitrageable Nearest correlation matrix computation Market data is the corner stone of the valuation process 18

20 Reconciliation process Valuation is only the first step In order to analyse discrepancies with the counterpart price it is necessary to compute: Price and sensitivities Expected cash flows Relevant implied parameters : call probability, barrier hitting probability Discrepancy sources Rarely models if methodological watch is performed Market data can be a source of discrepancy Bad knowledge of market practices such as calibration, hedging exotic parameters can be a source of discrepancy as well Reconciliation with counterparts valuations is key in the process 19

21 20 Credit risk Before the credit crisis Investment banks didn't price credit risk in structured products valuation Since Lehman collapse the market is pricing this risk It will lower the valuation of the note if the issuer has a spread over Libor positive Getting issuer's spread is complex : CDS Market, Bond Market... It can become the main risk factor of the product. Large spread can annihilate the value of the instrument Since Lehman collapse credit risk must be priced

22 21 Pricing Policy To calculate NAV : which price to take : counterparty s or third parties? Counterparty's prices are not independent Better proxy of unwinding levels? Consistency issues with other assets (synchronicity, forex ) No guaranty of quality (not an offer to buy or sell from the IB) Third party prices may be better than counterparty valuations. Still discrepancies have to be monitored. Transparency and high quality have to be given by the provider

23 Case Study 1 Price discrepancy analysis : taking into account liquidity and sensitivity to risk factors April 2011 Edhec Alternative Investment Days 2011 Laurent Thuillier

24 Case Study Zero coupon Inflation Swap Inflation SWAP : a vanilla product Maturity : 24 march 2029 (20 Y) Notional : GBP 56,000,000 Payoff : Client receives at maturity: Notional*((1+Rate)^20)-1) Client pays at maturity : Notional*(CPI(End) / CPI(Begin)-1) CPI : UK RPI which is the United Kindom inflation Index CPI(Begin) = Rate = 3.73% 23

25 Case Study Fixed leg : Straight forward calculation Fixed cash flow to be discounted Floating leg : Inflation SWAP : pricing methodology Calculation of the inflation curve Forecast the UK RPI level at maturity Discounting the evaluated cash flow Inflation curve is build from ZC inflation swap rate 24

26 Case Study CPI Forecast Inflation SWAP : pricing methodology 25

27 Case Study Inflation SWAP : price discrepancy SGSS MtM as of 04/02/ GBP CTY MtM as of 04/02/ GBP SGSS MtM drill down Fixed leg discounted : Floating leg discounted : ( ) Fixed leg undiscounted : Floating leg undiscounted : ( ) RPI forecast at Maturity : Discount Factor : Are those two prices consistent? What is the relevant measure? What is a reasonable threshold? 26

28 Case Study Inflation SWAP : price discrepancy 2 Measure 1: Absolute difference This difference is high This is not a good indicator since it does not reflect nominal effect Measure 2 : Relative difference (GBP GBP )/ GBP = 267% GBP GBP = GBP This difference is high This is not a good indicator for swap instrument Measure 3 : Relative difference 2 (GBP GBP )/GBP 56M = 75 basis point This difference is high It does not reflect the sensitivity of the product and the liquidity of the underlying data 27

29 Case Study Measure 4 : risk measure Inflation SWAP : price discrepancy 3 PV01 : Change of MtM for a 1 bp shift of the inflation curve PV01 as of 02/04/2009 = GBP Reasonable threshold = 5 basis point Reasonable difference is PV01*threshold = GBP Conclusion : our valuation is in line with the counterparty Taking into account liquidity Regarding this swap the main risk factor is the inflation curve 20Y tenor Bid-Ask spread on this point is important : 18 bp as of 02/04/ % 3.67% 3.76% 3.63% Bid 428,415 Mid Ask 997, , ,166 28

30 Case Study 2 Synergy between Collateral management and OTC valuation April 2011 Edhec Alternative Investment Days 2011 Laurent Thuillier

31 Case Study : collateral management On day D Client holds counterparty collateral Based on its valuations, the counterparty considers that it can recall the collateral SGSS blocks this collateral return as there is a significant difference (13 m ) between SGSS and Counterparty valuations on a portfolio of 7 Equity Options On day D+1 SGSS still blocks the margin call recall as no satisfactory explanation has been provided by the counterparty On day D+2 The Counterparty Front Office and SGSS pricing team get in touch to agree on a compromise A «mid» is performed on the 2 valuations (SGSS and counterparty) : counterparty lets 3 m on the Client collateral cash account 30

32 Conclusion To manage efficiently OTC s, 3 functions need to be involved : Managing OTC operations Managing independent valuations Managing the collateral Those three functions are interlinked Whether it is done internally by the asset manager or outsourced to a provider those functions need to be performed consistently 31

33 Collateral management : a new challenge April 2011 Edhec Alternative Investment Days 2011 Laurent Thuillier

34 Collateral New regulation : Dodd-Franck in the US & EMIR in Europe Standardized OTC will have to be cleared via CCP s by 2013 Live clearing offer for IRS and CDS It represents 80% of trade volume Impact on collateral processes : For uncleared OTC s : complex CSA on complex instruments 33

35 Collateral : a new world Impact on cleared OTC s Initial margin requirements Intraday margin calls Impact on uncleared OTC s Uncleared OTC are the more complex ones with exotic features Trend to use more complex CSA : independent amount, risk adjustment For both processes Manage eligibility Manage haircuts Market participants will have to source between 2 and 3 trillions USD of asset to face new collateral demand 34

36 Collateral : Cross-Margining Cross-Margining : one concrete example Cleared IRS for 10 M Non cleared Swaption for 10M Independently, total sum of margin call are 2M No risk offset 35

37 Collateral : optimisation Funding Transformation Repo to provide liquidity from ineligible trades Collateral optimisation Remuneration of unused collateral Cheapest to deliver Tri-party collateral offer : securing 36