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© 2015 - Proprietary and Confidential Information of FINCAD
How FINCAD can help navigate
Swap Strategies in the new
Regulatory Environment
Subbu Loganathan, Kramerica Consulting
Richard Weeks, Quantitative Analyst, FINCAD
© 2015 - Proprietary and Confidential Information of FINCAD
Agenda
• Introduction – How it all came to this
– Dodd Frank and EMIR Clearing and Margin – Good intentions,
unintended impact
– Basel III Capital Rules and Credit Risk – Consequences for the buy
side
– Increase in complexity post financial crisis
• Hedging Interest Rate Risk in the new environment
– Using cleared Interest Rate Swaps
– Collateralisation considerations
– Margin considerations
– LCH and CME – too big to fail?
• Managing Complexity using FINCAD F3
– Multiple curves
– Risk Reprojection
– Demo
• Q&A
2
© 2015 - Proprietary and Confidential Information of FINCAD
How it all came to this
• The financial crisis of 2007/08 was in part due to the lack
of transparency in the trading and processing of OTC
derivatives  It highlighted the need for data standards
and management of counterparty risk for OTC
instruments
“All standardized OTC derivative contracts should be traded
on exchanges or electronic trading platforms, where
appropriate, and cleared through central counterparties by
end-2012 at the latest. OTC derivative contracts should be
reported to trade repositories. Non-centrally cleared
contracts should be subject to higher capital requirements.”
September 2009
3
© 2015 - Proprietary and Confidential Information of FINCAD
The Regulatory Landscape now
4
MandatoryClearing
Structural Reform
AIFMD Volcker Rule Ring fencing Solvency II Basel III
Record Keeping (BCBS 239), (FSA49),
CASS, MiFiD II
RiskMitigationfor
UnclearedOTC–
VariationMarginand
InitialMargin
AppropriateCapital
Standardsforfinancial
instruments
RegulatoryTransparency
–TradeReportingand
DailyValuations
© 2015 - Proprietary and Confidential Information of FINCAD
Evolution of the Market post regulation
Source - http://www.bis.org/publ/qtrpdf/r_qt1312b.pdf
5
© 2015 - Proprietary and Confidential Information of FINCAD
Impact – Mandatory Clearing & Collateral
• Vanilla swaps cleared through CCPs
– IRS : LCH, CME, …
– CDS : ICE, …
– Mandatory clearing for vanilla swaps
– Variation margins + initial margins
• Specific to CCP, time varying rules,…
– Different supervisory bodies : CFTC, SEC, FCA, PRA, EBA, …
• Non mandatory cleared swaps
– Current ISDA + CSA
– Variation margins + bilateral IM
• Exemptions
– Sovereigns (unilateral CSAs), FX, covered bond swaps,
structured product swaps (no VM)
6
© 2015 - Proprietary and Confidential Information of FINCAD
Central Clearing Counterparties – A new Risk?
• Systemic Risk implications
– Market fragmentation, interoperability, waterfalls and pooling of
counterparty risks
– Initial margin vs. capital protection
– CCP Governance
• Rehypothecation of posted securities (and credit risk)
• Clearing membership
• Data processing and model risk when computing clearing
prices
• Product Scope
• Implication of competition among CCPs
– Initial Margin procyclicality
• Volatility Scaling
• Haircut dynamics
• Eligible collateral, thresholds
7
© 2015 - Proprietary and Confidential Information of FINCAD
Hedging Interest Rate Risk in the new landscape
• Buy-side clients with interest rate risk due to fixed income exposure
• look to swap the fixed coupons on their bond holdings into floating
coupons via swaps - Meaning they generally pay fixed on swaps
• O/N LIBOR rate vs LIBOR + OIS + CCP specific curve + collateralisation
8
0.6
0.65
0.7
0.75
0.8
0.85
0.9
0.95
1
0 2 4 6 8 10
Pre-Crisis Discount Curve
0
0.005
0.01
0.015
0.02
0.025
0.03
0.035
0 2 4 6 8 10
Pre-Crisis Forward Curve
© 2015 - Proprietary and Confidential Information of FINCAD
The CCP landscape for IRS today
• Increased complexity and fragmentation
– CCP interoperability
– ICE single name and index CDS, CFTC ruling
– Client clearing
9
© 2015 - Proprietary and Confidential Information of FINCAD
The CCP Market - LCH and CME
10
© 2015 - Proprietary and Confidential Information of FINCAD
LCH and CME – The origin of Swap basis spread
• Not all IRS can be cleared. If only a subset is centrally cleared, this
can result in increased margin costs and increased counterparty risk
exposure
– “Roughly half of IRS are out of scope of central clearing“– ISDA, 2012
11
© 2015 - Proprietary and Confidential Information of FINCAD
The case for FVA
• Funding books of swaps
– For fully collateralised contracts
• With no slippage risk at default
• Discount rates are tied to the (expected) rate of return of posted
collateral (EONIA or Fed funds rates in the most common cases)
• Calibration can be done on market observables with little
adaptation and thus little model risk - Collateralised OIS and Libor
swaps, possibly futures’ rates
– Uncollateralised contracts
• Generally a funding spread is used but may not be adequate
• We miss out-of-the money swap prices to calibrate discount
factors
– The funding rate
• Default-free : Funding/Lending rates essentially acts as the usual
short-term rate
12
© 2015 - Proprietary and Confidential Information of FINCAD
How F3 framework can help
1) Flexible Curve Modeling
1) Curve with OIS discounting
2) Curve with OIS discounting + CCP curves
3) Curve with OIS discounting + CCP curves + collateralisation – CVA/DVA/FVA
2) Risk Reprojection
1) Optimal Hedging of Interest Rate Risk based on Fixed Income Portfolios
2) Accounting for offsetting products like Futures
3) Scenario Analysis – Useful in Stress Testing for AIFMD/ Solvency II/Basel III
13
© 2015 - Proprietary and Confidential Information of FINCAD
Flexible Curve Construction
Richard Weeks, Quantitative Analyst, FINCAD
© 2015 - Proprietary and Confidential Information of FINCAD
15
Lazy Evaluation
Generic Calibration
Analytic risk
Scenario Analysis
Topical Example
1
2
3
4
5
© 2015 - Proprietary and Confidential Information of FINCAD
16
Lazy Evaluation
Generic Calibration
Analytic risk
Scenario Analysis
Topical Example
1
2
3
4
5
© 2015 - Proprietary and Confidential Information of FINCAD
17
F3 Object Model Overview
© 2015 - Proprietary and Confidential Information of FINCAD
18
Lazy Evaluation / Auto Calibration
Product Model Valuation
Method
input Δ?
request output
observe
Δ
no Δ
Cache
Output
© 2015 - Proprietary and Confidential Information of FINCAD
19
Lazy Evaluation
Generic Calibration
Analytic risk
Scenario Analysis
Topical Example
1
2
3
4
5
© 2015 - Proprietary and Confidential Information of FINCAD
Model
Calibration
Valuation
approach
A
Valuation
Approach
B
20
Abstraction
- Comparing instrument(s) value under
different valuation approaches
- Adjusting the value of model parameters
to optimize some metric based on the
difference in instrument(s) value under
the two approaches.
Model Calibration
© 2015 - Proprietary and Confidential Information of FINCAD
21
Generic Framework
Par
Closed
Form
Closed Form
Closed
Form
Closed
Form
Closed
Form
Target
Valuation
Source
Valuation
Optimizer
Instrument
Strategy
Calibration
Target
Model
© 2015 - Proprietary and Confidential Information of FINCAD
22
Hybrid modeling challenges
Generic Calibration
Analytic risk
Scenario Analysis
Conclusion
1
2
3
4
5
© 2015 - Proprietary and Confidential Information of FINCAD
• How can we calculate the risk numbers?
23
Risk Calculation Primer
- At least one bump
per market data
point, with
hundreds or more
market data points,
and can be
inaccurate
Bumping
- When calculating
the value, calculate
its first order
derivatives as well
& use the Chain
Rule from Calculus
to propagate them
across all market
data points
Analytic
risk
© 2015 - Proprietary and Confidential Information of FINCAD
24
Simple Example
© 2015 - Proprietary and Confidential Information of FINCAD
25
Simple Example
sum wy
ratio
square
z
u
v
x
© 2015 - Proprietary and Confidential Information of FINCAD
26
Simple Example
sum wy
ratio
square
z
u
v
x
© 2015 - Proprietary and Confidential Information of FINCAD
27
Simple Example
sum wy
ratio
square
z
u
v
x
© 2015 - Proprietary and Confidential Information of FINCAD
28
Simple Example
sum wy
ratio
square
z
u
v
x
© 2015 - Proprietary and Confidential Information of FINCAD
29
Simple Example
sum wy
ratio
square
z
u
v
x
© 2015 - Proprietary and Confidential Information of FINCAD
30
Simple Example
sum wy
ratio
square
z
u
v
x
© 2015 - Proprietary and Confidential Information of FINCAD
• Universal Algorithmic Differentiation (UAD) ™
– Automatically calculates the 1st order partial
derivatives without bumping
– Minimal incremental computing cost
– Numerical stability
31
Analytic Risk
© 2015 - Proprietary and Confidential Information of FINCAD
32
Analytic Risk - benefit
-
10
20
30
40
50
60
70
80
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33
CUMULATIVETIME(SECONDS)
NUMBER OF RISK EXPOSURES CALCULATED
CURVE BUMPING VS. F3 UAD
Curve Bumping Cumulative Time (seconds) F3 Risk Report Cumulative Time (seconds)
© 2015 - Proprietary and Confidential Information of FINCAD
33
Lazy Evaluation
Generic Calibration
Analytic risk
Scenario Analysis
Topical Example
1
2
3
4
5
© 2015 - Proprietary and Confidential Information of FINCAD
• Generic scenario framework that enables:
– Creation of simple and complex hybrid scenarios
– Global scenarios spanning asset classes & stress
factors
– Run stress-tests on entire portfolio
• Store definitions and output results
– Defensible audit trail & granular risk analysis
34
Scenario Generation
© 2015 - Proprietary and Confidential Information of FINCAD
© 2015 - Proprietary and Confidential Information of FINCAD
UAD risk computation efficiency with Risk Reprojection.
An example, If you want to hedge multiple term-structure exposures
using zero-coupon bonds for the respective term structures.
• How F3 constructs a reprojected model from the original model,
extracting the risk -report that will give exposures, reprojecting the
risk to a new set of instruments that were specified in the
reprojected model
• Result No need to re-define market data in this new reprojected
model since it is built from the original model, which contains the
market data.
36
F3 Risk Reprojection
© 2015 - Proprietary and Confidential Information of FINCAD
37
Lazy Evaluation
Generic Calibration
Analytic risk
Scenario Analysis
Topical Example
1
2
3
4
5

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The LCH CME swap basis another consequence of regulatory pressures

  • 1. © 2015 - Proprietary and Confidential Information of FINCAD How FINCAD can help navigate Swap Strategies in the new Regulatory Environment Subbu Loganathan, Kramerica Consulting Richard Weeks, Quantitative Analyst, FINCAD
  • 2. © 2015 - Proprietary and Confidential Information of FINCAD Agenda • Introduction – How it all came to this – Dodd Frank and EMIR Clearing and Margin – Good intentions, unintended impact – Basel III Capital Rules and Credit Risk – Consequences for the buy side – Increase in complexity post financial crisis • Hedging Interest Rate Risk in the new environment – Using cleared Interest Rate Swaps – Collateralisation considerations – Margin considerations – LCH and CME – too big to fail? • Managing Complexity using FINCAD F3 – Multiple curves – Risk Reprojection – Demo • Q&A 2
  • 3. © 2015 - Proprietary and Confidential Information of FINCAD How it all came to this • The financial crisis of 2007/08 was in part due to the lack of transparency in the trading and processing of OTC derivatives  It highlighted the need for data standards and management of counterparty risk for OTC instruments “All standardized OTC derivative contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties by end-2012 at the latest. OTC derivative contracts should be reported to trade repositories. Non-centrally cleared contracts should be subject to higher capital requirements.” September 2009 3
  • 4. © 2015 - Proprietary and Confidential Information of FINCAD The Regulatory Landscape now 4 MandatoryClearing Structural Reform AIFMD Volcker Rule Ring fencing Solvency II Basel III Record Keeping (BCBS 239), (FSA49), CASS, MiFiD II RiskMitigationfor UnclearedOTC– VariationMarginand InitialMargin AppropriateCapital Standardsforfinancial instruments RegulatoryTransparency –TradeReportingand DailyValuations
  • 5. © 2015 - Proprietary and Confidential Information of FINCAD Evolution of the Market post regulation Source - http://www.bis.org/publ/qtrpdf/r_qt1312b.pdf 5
  • 6. © 2015 - Proprietary and Confidential Information of FINCAD Impact – Mandatory Clearing & Collateral • Vanilla swaps cleared through CCPs – IRS : LCH, CME, … – CDS : ICE, … – Mandatory clearing for vanilla swaps – Variation margins + initial margins • Specific to CCP, time varying rules,… – Different supervisory bodies : CFTC, SEC, FCA, PRA, EBA, … • Non mandatory cleared swaps – Current ISDA + CSA – Variation margins + bilateral IM • Exemptions – Sovereigns (unilateral CSAs), FX, covered bond swaps, structured product swaps (no VM) 6
  • 7. © 2015 - Proprietary and Confidential Information of FINCAD Central Clearing Counterparties – A new Risk? • Systemic Risk implications – Market fragmentation, interoperability, waterfalls and pooling of counterparty risks – Initial margin vs. capital protection – CCP Governance • Rehypothecation of posted securities (and credit risk) • Clearing membership • Data processing and model risk when computing clearing prices • Product Scope • Implication of competition among CCPs – Initial Margin procyclicality • Volatility Scaling • Haircut dynamics • Eligible collateral, thresholds 7
  • 8. © 2015 - Proprietary and Confidential Information of FINCAD Hedging Interest Rate Risk in the new landscape • Buy-side clients with interest rate risk due to fixed income exposure • look to swap the fixed coupons on their bond holdings into floating coupons via swaps - Meaning they generally pay fixed on swaps • O/N LIBOR rate vs LIBOR + OIS + CCP specific curve + collateralisation 8 0.6 0.65 0.7 0.75 0.8 0.85 0.9 0.95 1 0 2 4 6 8 10 Pre-Crisis Discount Curve 0 0.005 0.01 0.015 0.02 0.025 0.03 0.035 0 2 4 6 8 10 Pre-Crisis Forward Curve
  • 9. © 2015 - Proprietary and Confidential Information of FINCAD The CCP landscape for IRS today • Increased complexity and fragmentation – CCP interoperability – ICE single name and index CDS, CFTC ruling – Client clearing 9
  • 10. © 2015 - Proprietary and Confidential Information of FINCAD The CCP Market - LCH and CME 10
  • 11. © 2015 - Proprietary and Confidential Information of FINCAD LCH and CME – The origin of Swap basis spread • Not all IRS can be cleared. If only a subset is centrally cleared, this can result in increased margin costs and increased counterparty risk exposure – “Roughly half of IRS are out of scope of central clearing“– ISDA, 2012 11
  • 12. © 2015 - Proprietary and Confidential Information of FINCAD The case for FVA • Funding books of swaps – For fully collateralised contracts • With no slippage risk at default • Discount rates are tied to the (expected) rate of return of posted collateral (EONIA or Fed funds rates in the most common cases) • Calibration can be done on market observables with little adaptation and thus little model risk - Collateralised OIS and Libor swaps, possibly futures’ rates – Uncollateralised contracts • Generally a funding spread is used but may not be adequate • We miss out-of-the money swap prices to calibrate discount factors – The funding rate • Default-free : Funding/Lending rates essentially acts as the usual short-term rate 12
  • 13. © 2015 - Proprietary and Confidential Information of FINCAD How F3 framework can help 1) Flexible Curve Modeling 1) Curve with OIS discounting 2) Curve with OIS discounting + CCP curves 3) Curve with OIS discounting + CCP curves + collateralisation – CVA/DVA/FVA 2) Risk Reprojection 1) Optimal Hedging of Interest Rate Risk based on Fixed Income Portfolios 2) Accounting for offsetting products like Futures 3) Scenario Analysis – Useful in Stress Testing for AIFMD/ Solvency II/Basel III 13
  • 14. © 2015 - Proprietary and Confidential Information of FINCAD Flexible Curve Construction Richard Weeks, Quantitative Analyst, FINCAD
  • 15. © 2015 - Proprietary and Confidential Information of FINCAD 15 Lazy Evaluation Generic Calibration Analytic risk Scenario Analysis Topical Example 1 2 3 4 5
  • 16. © 2015 - Proprietary and Confidential Information of FINCAD 16 Lazy Evaluation Generic Calibration Analytic risk Scenario Analysis Topical Example 1 2 3 4 5
  • 17. © 2015 - Proprietary and Confidential Information of FINCAD 17 F3 Object Model Overview
  • 18. © 2015 - Proprietary and Confidential Information of FINCAD 18 Lazy Evaluation / Auto Calibration Product Model Valuation Method input Δ? request output observe Δ no Δ Cache Output
  • 19. © 2015 - Proprietary and Confidential Information of FINCAD 19 Lazy Evaluation Generic Calibration Analytic risk Scenario Analysis Topical Example 1 2 3 4 5
  • 20. © 2015 - Proprietary and Confidential Information of FINCAD Model Calibration Valuation approach A Valuation Approach B 20 Abstraction - Comparing instrument(s) value under different valuation approaches - Adjusting the value of model parameters to optimize some metric based on the difference in instrument(s) value under the two approaches. Model Calibration
  • 21. © 2015 - Proprietary and Confidential Information of FINCAD 21 Generic Framework Par Closed Form Closed Form Closed Form Closed Form Closed Form Target Valuation Source Valuation Optimizer Instrument Strategy Calibration Target Model
  • 22. © 2015 - Proprietary and Confidential Information of FINCAD 22 Hybrid modeling challenges Generic Calibration Analytic risk Scenario Analysis Conclusion 1 2 3 4 5
  • 23. © 2015 - Proprietary and Confidential Information of FINCAD • How can we calculate the risk numbers? 23 Risk Calculation Primer - At least one bump per market data point, with hundreds or more market data points, and can be inaccurate Bumping - When calculating the value, calculate its first order derivatives as well & use the Chain Rule from Calculus to propagate them across all market data points Analytic risk
  • 24. © 2015 - Proprietary and Confidential Information of FINCAD 24 Simple Example
  • 25. © 2015 - Proprietary and Confidential Information of FINCAD 25 Simple Example sum wy ratio square z u v x
  • 26. © 2015 - Proprietary and Confidential Information of FINCAD 26 Simple Example sum wy ratio square z u v x
  • 27. © 2015 - Proprietary and Confidential Information of FINCAD 27 Simple Example sum wy ratio square z u v x
  • 28. © 2015 - Proprietary and Confidential Information of FINCAD 28 Simple Example sum wy ratio square z u v x
  • 29. © 2015 - Proprietary and Confidential Information of FINCAD 29 Simple Example sum wy ratio square z u v x
  • 30. © 2015 - Proprietary and Confidential Information of FINCAD 30 Simple Example sum wy ratio square z u v x
  • 31. © 2015 - Proprietary and Confidential Information of FINCAD • Universal Algorithmic Differentiation (UAD) ™ – Automatically calculates the 1st order partial derivatives without bumping – Minimal incremental computing cost – Numerical stability 31 Analytic Risk
  • 32. © 2015 - Proprietary and Confidential Information of FINCAD 32 Analytic Risk - benefit - 10 20 30 40 50 60 70 80 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 CUMULATIVETIME(SECONDS) NUMBER OF RISK EXPOSURES CALCULATED CURVE BUMPING VS. F3 UAD Curve Bumping Cumulative Time (seconds) F3 Risk Report Cumulative Time (seconds)
  • 33. © 2015 - Proprietary and Confidential Information of FINCAD 33 Lazy Evaluation Generic Calibration Analytic risk Scenario Analysis Topical Example 1 2 3 4 5
  • 34. © 2015 - Proprietary and Confidential Information of FINCAD • Generic scenario framework that enables: – Creation of simple and complex hybrid scenarios – Global scenarios spanning asset classes & stress factors – Run stress-tests on entire portfolio • Store definitions and output results – Defensible audit trail & granular risk analysis 34 Scenario Generation
  • 35. © 2015 - Proprietary and Confidential Information of FINCAD
  • 36. © 2015 - Proprietary and Confidential Information of FINCAD UAD risk computation efficiency with Risk Reprojection. An example, If you want to hedge multiple term-structure exposures using zero-coupon bonds for the respective term structures. • How F3 constructs a reprojected model from the original model, extracting the risk -report that will give exposures, reprojecting the risk to a new set of instruments that were specified in the reprojected model • Result No need to re-define market data in this new reprojected model since it is built from the original model, which contains the market data. 36 F3 Risk Reprojection
  • 37. © 2015 - Proprietary and Confidential Information of FINCAD 37 Lazy Evaluation Generic Calibration Analytic risk Scenario Analysis Topical Example 1 2 3 4 5