Collateralized discounting for Interest Rate Derivatives

As a result of 2008 credit crisis, interest rate OTC (over the counter) derivative markets have shifted from LIBOR discounting to OIS (Over night Index Swap) discounting due to increased use of collateralized transactions. The market players have realized that LIBOR rates can no longer be considered risk free yield curve due to embedded credit and liquidity risk. Collateral generally earns overnight cash rate relevant for its currency. Corresponding term cash rates are Overnight Index Swaps (OIS) rates. Spread between USD LIBOR and USD OIS has been very stable around 5-7 bps historically thereby justifying use Libor Curve for discounting cash flows. This worked until September 2007 when the initial blow ups due to US subprime crisis started surfacing and spread between Libor and OIS spiked higher and reaching peak of 350 bps at the time of Lehman bankruptcy. At this time market players have recognized that LIBOR no longer can be a workable proxy for risk free yield curve. Because LIBOR curve has bank credit and liquidity risk priced into it and vindicated by sky high LIBOR-OIS spreads. Consequently OIS rate became the risk free rate and hence a candidate for discounting cash flows, hence the name OIS discounting or CSA (Credit Support Annexes) Discounting.

Borrowing (funding) costs

Market cost of borrowing typically  depend on borrowing terms including, term life, secured or unsecured and credit worthiness of the borrower. Firm’s borrow cheaply at OIS (over night index Swap rate) rate where funds are collateralized with cash. Alternatively firms raise funds pledging securities like US Treasury notes instead of cash as collateral at Repo rates in Repo markets. Therefore borrowing at Repo rate represents cost of funds for collateralized borrowing and higher than the OIS rate. Firms also raise funds that are not collateralized by lien to any specific assets at much higher rates. This type of uncollateralized funding is driven by factors like borrower’s credit risk. CDS (credit default swap rates) and Cash bond spreads provides reasonable estimate for this type of cost of funding and will be typically much higher than the repo rate and the OIS rate. Typically CDS rates are lower than Bond yields in the near term. As the term to maturity increases we see Bond yields lower than CDS market levels

Many OTC derivative transactions follow CSA (credit support Annexes). These CSA’s terms will govern the underlying collateral to be posted. Sometimes, collateral posted in same currency as the underlying transaction cash flow currency leading to single currency CSA discounting and other times, collateral currency is different from the Transaction currency resulting in multi currency CSA discounting.

Single Currency CSA Discounting:

Single Currency CSA discounting is same as OIS discounting. In this case CSA collateral to be posted in a currency is same as the currency of the transaction’s cash flows and discounted using transaction (or collateral) currency OIS rate. OIS rate is readily available from market observed OIS rates.

Multi currency CSA Discounting:

 In the case of Multi currency CSA collateral to posted in a currency other than the currency of the transaction’s cash flows. Then Cash flows are discounted at the OIS rate (Collateral currency) and adjusted by cross currency FX basis between collateral currency OIS Rate and transaction currency OIS rate. Although OIS rates are readily observable in the market but not OIS implied FX basis spreads. At the same time there are active market quotes for LIBOR cross currency swaps are available. Under arbitrage free framework, FX basis spreads implied from LIBOR cross currency swaps should be same as implied from imaginary OIS based cross currency swaps. Using these cross currency basis swaps along with the collateral currency OIS rate we can perform CSA based discounting in multi currency framework.

CSA discounting is applied to Interest Rate derivative products. This include, IR swaps, Swaptions, Caps&Floors and CMS products.