The migration from discounting based on LIBOR, or a similar rate, to a rate such as OIS that is more reflective of the funding benefits obtained from the collateral posted has been, and continues to be, an evolutionary process. The degree of market acceptance and, thus, inclusion of OIS discounting within pricing may vary across asset classes. For example, typically the adoption of OIS discounting for interest rate products has been more pervasive, whereas for other asset classes the adoption of OIS discounting is occurring at a slower pace.
In addition, the appropriate valuation basis may be different depending on the currency underlying the transaction and the currency of the collateral eligible to be posted. The most liquid currencies (e.g., US dollar or euro) may have observable market data for the OIS rate over the remaining life of the derivative portfolio. Other currencies may have observable OIS rates for short dated exposures, and some emerging market currencies may not have a similar reference market input. In some cases, the availability of reliable data has impacted market participants’ behavior with respect to pricing. The lack of consistent data is a reason the pace of adoption of OIS discounting is slower for certain products and in some markets.
As a result, reporting entities should assess the appropriate valuation basis for their derivative transactions for each class of transactions separately. Class of transactions refers to:
- the type of derivative contract,
- the underlying risk,
- the tenor of the contract, and
- the nature of the collateral and the terms under which it is posted.
Different collateral terms across different Credit Support Annexes
In the example of a fully cash collateralized interest rate swap, it may be appropriate to apply OIS discounting. However, CSA terms may vary across companies and counterparties and will require further evaluation.
Examples of CSA terms that may require evaluation include the existence of thresholds below which collateral posting is not required, the ability to post collateral in different currencies, the ability to post collateral that may not be readily rehypothecated (such as certain corporate or asset backed securities for example), or contractual features that prohibit the rehypothecation of collateral.
Reporting entities should evaluate the collateral terms and assess how those features would impact the valuation approach. Such assessments require judgment about the substance of the collateral terms. For example, in principle, the valuation of the uncollateralized portion of transactions subject to collateral thresholds should be considered differently than the collateralized portion. In practice, when pricing transactions, market participants may make operational approximations in pricing models to treat trades as fully collateralized or fully uncollateralized. The classification of transactions may consider positions with collateral thresholds that are set at a relatively low level compared to the derivative exposures to be in-substance collateralized. Thresholds that are set at a level such that the likelihood of either party having to post collateral is remote may mean that a market participant considers the position to be in substance uncollateralized.