Derivatives Valuation Pricing Approaches PDF

FINANCIAL SERVICES
New valuation
and pricing
approaches for
derivatives in
the wake of the
financial crisis
Moving towards a new
market standard?
October 2011
kpmg.com
Contents
1. A new valuation and pricing framework
2. Collateralized deals
3. Uncollateralized deals
4. Implications for bank management
5. What institutions need to do now
6. References
© 2011 KPMG International. KPMG International is a Swiss cooperative. Member firms of the KPMG network of independent firms are affiliated with KPMG International. KPMG International provides no
client services. No member firm has any authority to obligate or bind KPMG International or any other member firm vis-à-vis third parties, nor does KPMG International have any such authority to obligate or bind
any member firm. All rights reserved.
New valuation and pricing approaches for derivatives in the wake of the financial crisis | 3
1. A new valuation and

pricing framework
As a result of the financial crisis, the ‘old’ Reasons for the move towards the consideration of funding costs in the
derivatives valuation framework with new valuation methods: valuation of uncollateralized deals does
one master swap curve for discounting not go beyond the collection of ideas.
and projection of forward rates no • Widening of basis spreads: The Consequently, the corresponding risk
longer applies. swap rate associated with a swap management and transfer pricing
vs. 6M LIBOR no longer coincides questions are very much under review
In particular, the crisis revealed
with the swap rate of a swap vs. and discussion.
differences in value between
collateralized and uncollateralized 3M LIBOR given the same currency
trades, which were negligible before. and maturity. OIS – LIBOR spreads
have also widened considerably.
Collateralized trades must be
theoretically discounted with the agreed • Collateral: To mitigate counterparty
collateral rate (mostly an overnight index risk, most of the interbank OTC
swap (OIS) rate)1 (see e.g. Piterbarg trading is now carried out on a
(2010), Fujii et al (2009a, 2009b, 2009c)). collateralized basis, i.e. daily
Due to the small basis spreads and the changes to the mark-to-market
low volatility of those, this valuation value of the derivatives are balanced
concept never played a major role. With via collateral accounts. Details Dr. Daniel Sommer
raising and volatile spreads discounting regarding the daily margining Head of Financial Risk Management
collateralized cashflows with the CSA process are described in the KPMG in Germany
rate is no longer a purely theoretical so-called Collateral Support Annex
concept, but has become material. (CSA) agreement.
On the other hand, the price at which • Funding cost: The assumption
an institution would trade an that banks fund themselves at
uncollateralized deal is related to the the LIBOR rate is no longer valid.
cost of funding of the respective This is particularly the case for
institution (see e.g. Fries (2010), Morini longer tenors.
and Prampolini (2011), Burgard and Kjaer
(2009), Piterbarg (2010) etc.). As funding
Matthias Peter
spreads dramatically increased, their reflects the different approaches
Senior Manager, Risk Consulting
consideration in the pricing and the with regard to CSA and funding cost
Financial Risk Management
valuation makes a big difference. related discounting in these two
KPMG in Germany
respective groups.
KPMG has carried out an industry
survey on CSA and funding cost related The interviews and subsequent
discounting which also addresses the evaluation of the questionnaires carried
transfer pricing and risk management out by KPMG reveal that CSA
topics arising from the transition to the discounting has become the market
new discounting regime. The target standard for pricing collateralized deals,
group consists of 18 banks from 10 and will become the market standard for
countries. KPMG classified the banks valuation at trade level. In contrast to the
in two groups on the basis of their accepted methodology for the valuation Dr. Barbara Götz
trading activities and balance sheet of collateralized deals, the treatment of Manager, Risk Consulting
size: major international and medium uncollateralized deals is still open to Financial Risk Management
sized institutions. This classification discussion. For most of the institutions KPMG in Germany
1 In the following CSA discounting or in case of an OIS rate paid

on the collateral OIS discounting.
4 | New valuation and pricing approaches for derivatives in the wake of the financial crisis
2. Collateralized deals
The survey shows that all banks have Looking at overall implementation The implementation is currently being
dealt with CSA discounting approaches status, we found that major banks have rolled out to all essentially affected
for some time and have a well-defined switched the pricing to CSA discounting asset classes. Curiously, a move to
idea regarding its implementation. and consider this effect in valuation. CSA discounting in equity markets is
In the interviews carried out for our Most banks currently report an offline evident, but not at the same scale as
survey, and from projects done in this P&L adjustment and intend to switch to for the interest rate business. Some
field, we get the impression that major a CSA based valuation at trade level by institutions, especially medium sized
banks are driving the transformation of 2012. Medium-sized banks seem to lag banks, still withhold from planning an
the market towards CSA discounting, behind in the switch to CSA discounting. implementation of CSA discounting
whilst medium sized banks (though Not all survey participants have adopted for this asset class in the short-term.
perhaps alerted in the first place by CSA discounting for pricing yet, and the
the announcement of some early bird In the institutions that have partly
time horizon for the implementation of
to switch its collateral management implemented CSA discounting, the
the valuation spans the next 1-3 years.
valuations to CSA discounting) lag behind implementation has started with the
in the implementation process. Due The implementation in many banks economic valuation but has not yet been
to current developments, such as the is driven by materiality assessments extended to processes such as collateral
adoption of CSA discounting by central and pragmatism. Major banks have management, risk measurement or fair
clearing services and a high regulatory commenced their implementation with value accounting.
pressure to move to central clearing, the most critically affected asset class,
this market transformation has i.e. interest rate derivatives, and the
become irreversible. most highly impacted product types,
e.g. long-running FX or inflation
products. This has in some cases led
to inconsistencies in the valuations
used between desks. Some institutions
cured these valuation inconsistencies by
running a parallel infrastructure capable
of both CSA and Libor discounting.
Figure 1
Survey result – When do you plan to go live with your CSA discounting methodology?
Major international banks
2010 2011 2012
Pricing All eight banks have implemented the pricing
Pricing & Valuation 2 1 2 3
Medium sized banks
2010 2011 2012
Pricing Seven banks have already implemented the pricing (two of them implemented it only
for IR business), the remaining are further behind in the implementation (2012-2014)
Pricing & Valuation 2 3 2 1 1
Materiality assessment is also key Figure 2

Survey results – For which asset classes are you using/planning to use CSA discounting?
when it comes to model CSA specifics.
This is particularly the case when
considering amongst other issues Valuation: Major international banks
minimum transfer or threshold amounts
as well as the various eligible currencies Vanilla products Exotic products
to post collateral. The institutions only Credit derivatives
5 1 1 4
plan to model CSA clauses explicitly
where these deeply impact the value of 4 1 Equity derivatives 1 4
their portfolio and where these can be
economically hedged and, thus, market 3 5 Interest rate derivatives 3 4 3
data rather than historic data is available
for modeling purposes. Therefore 6 2 FX derivatives 1 6
none of the participants actually plan Energy / Commodities /
3 2 3
to incorporate convexity adjustments Developing Products
in moving from collateralized to
8 6 4 2 0 0 2 4 6 8
uncollateralized measures or to different
currency measures. Though institutions Implemented Planned
seem to incorporate the collateral
currency in their discount factors, the
embedded multi-currency optionality
is only valued with its intrinsic value. Valuation: Medium sized banks
The right of the collateral posting Vanilla products Exotic products

counterparty to switch the collateral 9 Credit derivatives 9
currency as soon as another eligible
currency becomes the cheapest to 8 Equity derivatives 8
deliver can actually be seen as an option
on the cross-currency basis spreads. 10 Interest rate derivatives 10
One institution stated it may be

8 FX derivatives 7
inappropriate to consider the time value
of this option due to the lack of a market 6
Energy / Commodities /
6
Developing Products
in which to hedge the resulting vega
risk. Minimum transfer and threshold 10 8 6 4 2 0 0 2 4 6 8 10
amounts tend to be only modeled in
case of concentration risk, otherwise Planned
a pragmatic approach is applied: An
assessment is carried out whether the
counterparty should be classified as
collateralized or unsecured based on the
size of the minimum transfer amounts
and minimum threshold agreements,
as well as the exposure towards the
respective counterparty.
Compared to the pragmatism with With respect to the valuation of cross- Figure 4
Survey Result – Do you (plan to) consider the
which the institutions deal with other currency swaps the majority of the
currency of the respective collateral posted when
CSA clauses, the consideration of participants follows the approach building the discount curve?
eligible collateral currencies in their taken for vanilla swaps – collateralized
valuation appears to be an important in a currency which is not the deal Major international banks
detail for the survey participants. This is currency and adjust the discount factor
remarkable considering the difficulties correspondingly. Some of the medium-
and efforts the institutions may have sized banks are still undecided as this
to face. question is linked to the choice of the
basis currency for the cross-currency 3
So far none of the standard front
swaps. Even though the markets mostly
office systems actually supports the
quote and trade cross-currency swaps
introduction of discount curves, which
with USD leg flat, institutions with a 5
depend not only on the deal currency
focus on EUR convert the quoted basis
but also on the collateral currency.
spreads quoted based on USD flat
to basis spreads with EUR flat
In the near future the multi-currency
and apply these for valuation and
issue might even become irrelevant
portfolio hedging.
– at least for new deals (except Medium sized banks
for cross-currency trades in less The markets and currencies for which
important currencies) – when the new OIS discounting will be applied reflect 1
standardized ISDA CSA2 is released and again the relevance of each of the
central clearing becomes obligatory. markets for the respective institution. 3
This new standard is thought to solve, While most banks will build OIS curves
among others, the multi-currency in the big six currencies, EUR, USD,
issue by introducing single currency GBP, JPY, CHF and AUD, some banks
cash collateral accounts. However, it is which are heavily involved in emerging
apparently essential for the institutions markets build curves for these markets
6
to be capable of measuring the value as well. Rather than sticking with Libor
differences when back-loading existing discounting for markets with illiquid
trades to central counterparties or single overnight swap markets, institutions
currency CSAs. started to build synthetic OIS curves Yes, implemented
by using a liquid proxy adjusted by the Yes, planned
All international and nearly all medium Undecided
cross-currency basis.
sized institutions stated their aim to No
build discount curves while considering
collateral and deal currency.
2 See also RISK August 2011
3. Uncollateralized deals
The price at which an institution would Having realized the impact of the new Several contacts informed us that their
trade an uncollateralized deal is related valuation approach for collateralized traders argue for the latter approach
to the cost of funding of the respective deals, medium sized institutions have because they prefer an approach at
institution. From the survey, we initiated comprehensive projects trade level rather than at portfolio level.
obtained the impression that the which work on topics such as multi- At least one of these banks will try to
majority of the banks plans to consider curve set-ups, CSA discounting and the implement a parallel infrastructure –
their own funding costs in the valuation valuation of uncollateralized deals. If a corrected DVA on portfolio level for
of uncollateralized deals in some form. they proceed as planned, the medium- the accounting P&L and funding cost
sized institutions might even be early discounting for the economic P&L.
Cost of funding discounting is one
birds with respect to the introduction The funding curve would be determined
of the valuation approaches banks
of a new valuation approach for in such a way that both approaches can
consider. Another approach might
uncollateralized deals. Most of these be reconciled. The reconciliation task
be CVA/DVA with a funding value
smaller institutions plan to follow a cost is not trivial, as the P&L effects from
adjustment. However, there is still
of funding discounting approach. diversifications and concentrations
no clear market view yet as to which
need to be broken down to trade level.
valuation methodology and which A reason for the reluctance of major
This might be one of the reasons the
curve construction should be chosen institutions to move forward may lie in
institutions still seem to be rather
and/or how cost of funding is actually their counterparty risk measurement
undecided on the issue.
determined. This is especially true infrastructure. Many of them have
for the group of major international adopted a symmetric CVA/DVA In summary, there are various ideas
institutions – the valuation of approach. They are, as a result, forced to derive the actual discounting curve
uncollateralized deals seems to be still to handle the double counting problem for uncollateralized trades. Institutions
under discussion and implementation when they wish to implement planning to adopt a funding cost
plans are very vague. funding cost discounting or to discounting approach mostly tend to
switch the method. determine the spread based on an
analysis of their current short-term and
long-term (unsecured) funding costs.
Others use the average of their current
funding mix or short-term funding costs
only. Institutions which favour keeping
Figure 5 or implementing a CVA/DVA approach
Survey Result – Do you use/plan to use a CVA/DVA approach in pricing uncollateralized derivatives? stick to Libor discounting and might
adjust the DVA by the bond-CDS basis.
Major international banks Medium sized banks
10 10
8 8
1
6 6
4 6 4
6
2 1 2 3
1 1
CVA/DVA CVA only None CVA/DVA CVA only None
Implemented Planned
Weighing up the techniques On the positive side, funding cost

In our opinion, some issues can be discounting can create transparency
brought forward for and against funding about the actual costs of a business
spread discounting. Discounting model. Incorporating the full funding
based on own funding spread renders spread in pricing derivatives might be
a rather subjective valuation and detrimental for some business units.
P&L allocation of uncollateralized Banks may, therefore, choose not to
deals. The ‘one’ funding spread include them fully in their pricing, but
curve to be applied for the valuation at least they are made aware of the
of uncollateralized derivatives does true long-term costs of their business
not exist. At first glance, you would and their business model.
expect that the funding grids applied
Comparing an adjusted DVA approach
for transfer pricing on the asset or
and funding cost discounting, it is clear
liability side are an obvious choice for
that liquidity and credit components in
the discounting curve. However, closer
the spreads are difficult to disentangle.
analysis is required because those
As funding cost discounting comprises
grids usually incorporate business
both and can be furthermore applied at
incentives and do not necessarily
trade level rather than at portfolio level,
reflect the current funding level. The
funding cost discounting seems to be
funding spreads applied to value own
preferable to an adjusted DVA approach.
unsecured liabilities – blended with
short-term funding spreads – might
be an alternative. The question about
the correct market value cannot be
answered easily because the value of
the trade now depends on the owner
and his funding spread. This is especially
relevant in case of novations.
4. Implications for bank management
The discussions about the true funding However, we got the impression second order effects on the funding
cost may have already revealed that the that – while treating internal deals as needs and benefits arising from the
new valuation schemes deeply affect collateralized in the valuation – not all underlying trades.
transfer pricing between derivative banks participating in the study appear
Additionally, under both schemes,
desks and treasury/funding functions to have implemented the respective
i.e. in case that cost allocation or
on one hand, and between treasury/ cash processes involved with a
internal collateral accounts are
funding functions and loan units on the collateralized set-up.
implemented, each desk is responsible
other. This has called previous transfer
Rethinking existing transfer pricing to hedge mismatches arising when an
pricing approaches into question.
schemes and risk management uncollateralized derivative is hedged
Due to the ongoing discussion about From our point of view, collateralized with a collateralized one.
the valuation of uncollateralized deals, internal trades must be set up in a
Analogously to a CVA the funding needs
transfer pricing and risk management is consistent transfer pricing framework
and benefits from collateralized and
still under review at most institutions. for funding costs from the derivatives
uncollateralized trades could also be
One thing, however, seems to be clear: business in the bank. This transfer
transferred to a central desk via upfront
internal deals are, or will be, valued as if pricing framework should not
fees or internal trades. This central desk
they are collateralized in all institutions differentiate between internal and
would manage the funding needs of the
participating in the survey even though external trades in order to avoid internal
derivatives business and the second
an uncollateralized set-up could also be arbitrage opportunities.
order effects of the underlying market
conceptually operationalized.
Another objective of the transfer movements on the funding of the
There could be manifold reasons for the pricing scheme must be to allocate collateral pool. A central desk ensures
popularity of the collateralized valuation funding costs and benefits from that netting effects over all desks can
set-up. Applying CSA discounting to internal and external (collateralized or be exploited and that the funding needs
internal trades provides the bank with uncollateralized) derivatives to the unit of the capital market business can be
an objective valuation method for where they have been generated. From pooled. However, the installation of an
internal trades which is not dependant projects done in this field we gather that additional desk can be quite costly.
on subjective assessment. Most of the the actual design of the transfer pricing The last alternative is, thus, chosen by
external derivatives trades are carried scheme depends on the business some of the banks with major capital
out on a collateralized basis. Valuing model of the bank and the size of the market operations.
the internal trades as collateralized trading area of the respective bank.
In the evaluation of the study we found
ensures that there is no advantage The cost of collateral may be distributed
that not many of the participating
of doing trades externally rather than retrospectively, e.g. in a monthly run,
institutions consider a link between
internally. Furthermore, in case of an to the respective desks and business
internal derivative trades and internal
adoption of funding cost discounting for units (e.g. loan units) considering
loan/deposit (funding deals), e.g.
uncollateralized deals, the valuation of collateral on internal and external
between the treasury/funding functions
internal trades as uncollateralized would trades. This approach fits a passive
and the loan business units. We think
lead to the introduction of funding management of the funding needs
that a consistent transfer pricing
spread risk at every desk in the bank. and benefits from the derivative area.
framework must comprehend internal
For institutions with larger trading derivatives as well as internal funding
operations a set-up with internal tickets to avoid arbitrage opportunities,
collateral accounts and daily e.g. in the form of internal block trades.
margining for the external and internal This is especially true for institutions
collateralized trades at each desk is which incur a big derivative portfolio to
thinkable. As a consequence, each desk support their loan business.
is responsible for the management of
5. What institutions need to do now
The relevance of CSA and funding Key actions

related valuations originates from
fundamental changes in the markets • In order not to be arbitraged out,
since the beginning of the each institution must adopt CSA
financial crisis. discounting for collateralized deals,
Driven by the fast implementation at least for asset classes where the
of CSA discounting by central market indicates that most of the
counterparties and major banks, CSA banks have switched their pricing to
discounting has already become the the new method.
market standard for pricing collateralized • In times of rising funding costs, no
interest rate derivatives, and is about bank can afford to ignore its funding
to become the market standard for costs. The economic valuation of
valuation of collateralized derivatives at uncollateralized deals should be
trade level. However, a market standard linked to the actual funding spread
framework for uncollateralized deals of each bank. A business model
consistent with the existing valuation which does not allow to fully price
infrastructure does not yet exist. in its actual cost of funding is not
In light of this, financial institutions feasible in the long-term.
need to rethink their pricing, valuation • CSA or funding related valuation is
and transfer pricing. not a pure playground for quants, but
rather a topic that evokes questions
about transfer pricing, steering
of risk and, most importantly, the
business model of each bank.
References
C. Burgard and M. Kjaer (2010): PDE M. Fujii, Y. Shimada and A. Takahashi

representations of options with bilateral (2009c): A Market Model of Interest
counterparty risk and funding costs, Rates with Dynamic Basis Spreads in
Working Paper. the Presence of Collateral and Multiple
Currencies, CARF Working Paper Series.
C. Fries (2010): Discounting Revisited.
Valuations under Funding Costs, M. Morini and A. Prampolini (2011):
Counterparty Risk and Collateralization, Risky funding with counterparty and
Working Paper. liquidity charges, Risk March 2011, p.
70-75.
M. Fujii, Y. Shimada and A. Takahashi
(2009a): A Note on Construction of V. Piterbarg (2010): Funding beyond
Multiple Swap Curves with and without discounting: collateral agreements and
Collateral, CARF Working Paper. derivatives pricing, Risk February 2010,
p. 97-102.
M. Fujii, Y. Shimada and A. Takahashi
(2009b): A Survey on Modeling and N. Sawyer (2011): New standard
Analysis of Basis Spreads, CARF CSA could be rolled out in Q2 2012,
Working Paper. http://www.risk.net/risk-magazine/
news/2105291/standard-csa-
rolled-q2-2012.
Contacts
Daniel Sommer
Head of Financial Risk Management
KPMG in Germany
T. 49 69 9587 2498
E. dsommer@kpmg.com
Matthias Peter
Senior Manager, Risk Consulting
KPMG in Germany
T. 49 69 9587 1649
E. mattiaspeter@kpmg.com
Dr. Barbara Götz

Manager, Risk Consulting
KPMG in Germany
T. 49 89 9282 4601
E. barbaragoetz@kpmg.com
Giles Williams
Partner, Financial Services
Regulatory Centre of Excellence,
EMA region
KPMG in the UK
T. 44 20 7311 5354
E. giles.williams@kpmg.co.uk
© 2011 KPMG International Cooperative (“KPMG International”), a Swiss entity. Member firms of the KPMG network of independent firms
are affiliated with KPMG International. KPMG International provides no client services. No member firm has any authority to obligate
or bind KPMG International or any other member firm vis-à-vis third parties, nor does KPMG International have any such authority to
obligate or bind any member firm. All rights reserved.
The KPMG name, logo and “cutting through complexity” are registered trademarks or trademarks of KPMG International.
The information contained herein is of a general nature and is not intended to address the circumstances of any particular individual or
entity. Although we endeavour to provide accurate and timely information, there can be no guarantee that such information is accurate
as of the date it is received or that it will continue to be accurate in the future. No one should act on such information without appropriate
professional advice after a thorough examination of the particular situation.
Produced by KPMG’s Global Financial Services Practice in the UK.
Designed by Mytton Williams
Publication name: New valuation and pricing approaches caused by the financial crisis: Moving towards a new market standard?
Publication number: 314799
Publication date: October 2011

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FINANCIAL SERVICES

1. A new valuation and pricing framework

4. Implications for bank management

5. What institutions need to do now

1. A new valuation and

1 In the following CSA discounting or in case of an OIS rate paid

Major international banks

2010 2011 2012

Pricing All eight banks have implemented the pricing

Pricing & Valuation 2 1 2 3

Medium sized banks

2010 2011 2012

Pricing & Valuation 2 3 2 1 1

Materiality assessment is also key Figure 2

The right of the collateral posting Vanilla products Exotic products

One institution stated it may be

2 See also RISK August 2011

Weighing up the techniques On the positive side, funding cost

4. Implications for bank management

5. What institutions need to do now

The relevance of CSA and funding Key actions

C. Burgard and M. Kjaer (2010): PDE M. Fujii, Y. Shimada and A. Takahashi

Dr. Barbara Götz

Produced by KPMG’s Global Financial Services Practice in the UK.

Designed by Mytton Williams

Publication number: 314799

Publication date: October 2011

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1. A new valuation and

1 In the following CSA discounting or in case of an OIS rate paid

2 See also RISK August 2011