Derivatives

OTC derivatives pricing models offer user volatility input

Derivatives pricing and risk management vendor Savvysoft has added new pricing models that use yield curves from overnight index swaps (OIS) and give end users the ability to factor in volatility calculations.

The firm’s new interest rate derivative pricing models combine yield curves calculated using LIBOR and OIS data, which generate collateral costs of Interest rate swaps (IRS) trades.

Robert Stowsky, senior analyst at consultancy Aite, said: “The market is really starting to look at a multi-curve approach.” He pointed out that global OTC derivatives clearing house LCH.Clearnet had chosen an OIS model for collateral and valuation.

“The key draw for using an overnight curve are the collateral requirements now in place for swaps,” Stowsky said. “When you have a collateral swap, the collateralisation affects the value of the swap. By taking the OIS curve into the model you’re taking that into account.”

One of the new models, Savvysoft’s dual curve swaption model, lets users set a parameter specifying how the two curves move relative to one another due to volatility.

Implied volatility is essential in options pricing and many firms have proprietary approaches. Stowsky said this function would be appealing as firms can insert their own volatility forecasts.

The model generates its OIS curve through a combination of short-term Fed Funds rates, Fed Funds futures, and OIS data. The matching LIBOR curve, an aggregated adaptation of the standard calculation method, takes into account short-term LIBOR, Eurodollar futures and IRSs. It also discounts LIBOR-based cash flows at OIS rates.

In a statement, Savvysoft said IOS data was growing in popularity for derivatives pricing in light of scandal around manipulation of the LIBOR benchmark. Authorities including the Financial Accounting Standards Board (FSAB) have adopted the OIS on Federal Funds as a more secure barometer for pricing interest rate instruments than LIBOR.

Savvysoft amalgamates the two yield curves that can be applied to a range of interest rate instruments including non-cancellable swaps, swaptions, cancellable swaps, caps and floors.

 

Bob Newstead, Global Head of Product a benchmark provider RVS, said: “OIS discounting appears to be the preferred measure within the market-making community as it better reflects their funding method and is therefore a more accurate hedge of their risks.”

 

Many authorities, such as the Financial Accounting Standards Board (FASB) have adopted the OIS on Federal Funds as a more secure barometer for pricing interest rate instruments than LIBOR, largely due to margin calculations showing more accurate counterparty risk.

By Jessica King