Market participant assumptions related to the valuation of financial instruments continue to evolve, even for “plain vanilla” products. Some changes result from the market’s response to dislocations observed during the credit crisis. Others result from the natural evolution in markets or valuation theory and practice.
Examples of recent evolutions in valuing financial instruments include the use of overnight index swap (OIS) discounting and funding valuation adjustments (FVA).

6.7.1 OIS discounting — US GAAP

Derivative dealers and many end users have utilized collateral for many years to mitigate the risk of default by a party to the transaction. For bilateral transactions (i.e., those entered into between two parties and not cleared through a clearing house), the collateral posting has commonly been governed by a Credit Support Annex (CSA) to the International Swap Dealers Association, Inc. Master Agreement or similar agreements between the parties.
The terms of a CSA typically address:
  • the nature of the collateral permitted to be posted (e.g., US dollar cash or Treasuries),
  • how the amount of that collateral will be calculated,
  • what interest rate is required to be paid on collateral amounts deposited with the other party (often based on the Fed Funds rate for cash posted in US dollars), and
  • whether the parties to the derivative transaction have the right to use the amount posted as collateral for other business purposes (rehypothecation rights) or if it must be held in segregated accounts.
During the financial crisis, market participants observed that collateral previously considered to principally mitigate credit risk could also provide a significant funding benefit. Cash deposits received under CSAs typically require interest payments at a low rate (such as the Fed Funds rate), and the collateral balances essentially represented a low cost source of funding if amounts posted were available for use and acceptable as collateral. As a result, the economic benefit of these collateral terms began to be incorporated in transaction pricing by derivative dealers. The benefits are typically incorporated by discounting the cash flows on transactions using a rate that approximates the collateral funding rate (such as the OIS rate for collateral on which interest was paid at the Fed Funds rate) rather than a rate such as the London InterBank Offered Rate (LIBOR).
Cash collateral may be posted in other major currencies, such as sterling, euro, and yen, resulting in pricing based on discounting using the corresponding OIS-equivalent rate (Sterling OverNight Index Average, Euro OverNight Index Average, or Yen OIS, respectively). Similarly, when acceptable securities are posted as collateral, the economic benefits may be realized by placing such securities on deposit with central banks, or by entering into collateralized repurchase agreements.
Discounting at OIS by dealers and their customers to incorporate this funding benefit on collateralized transactions has evolved in the past several years, and has been more consistently applied over that time. This can be seen in the bilateral market in trading activity, which is increasingly based on OIS discounting, and in the financial statement disclosures of leading financial services firms.
Others have also noted that pricing is evolving to incorporate consideration of the funding benefit. In 2013, the FASB permitted the Fed Funds Effective Swap Rate (or OIS) to be a benchmark interest rate for purposes of applying the hedge accounting guidance. At the time, the FASB noted in the basis for conclusions that the exposure to OIS had increased as a result of the financial crisis. The FASB further noted that the use of OIS as a discount rate to value collateralized derivatives had increased because that rate reflects the lower cost of financing a collateralized instrument. OIS discounting — an illustration

The Fed Funds rate is the interest rate at which depository institutions actively lend balances held at the Federal Reserve to each other, usually on overnight terms. Institutions with surplus balances in their accounts lend those balances to institutions in need of larger balances. The weighted average of this rate across all such transactions on any given day is the daily Fed Funds effective rate. The related Fed Funds Effective Swap Rate, or OIS, is the fixed rate on an interest rate swap that has its variable-rate leg referenced to the Fed Funds effective rate. That fixed rate is the derived rate that would result in the swap having a zero fair value at inception because the present value of fixed cash flows, based on that rate, equates to the present value of the variable cash flows.
To price a derivative instrument, such as an interest rate swap, valuation models typically estimate the future contractual cash flows the counterparties agree to exchange periodically over the life of the contract. Historically, entities have approximated the mid-market value of the transaction by discounting those cash flows based on the LIBOR discount rate.
As a result of the evolution in the market for collateralized transactions, most major derivative dealers discount the cash flows on certain derivative transactions at a rate appropriate to the terms of the collateral (for bilateral derivatives) or variation margin (for cleared agreements).
A common example is a derivative transaction executed with a CSA, which requires that:
  • US dollar cash collateral must be posted daily to offset the full mid-market value of the swap (i.e., zero threshold)
  • the party receiving collateral must pay interest on the collateral amounts deposited at the Fed Funds rate
  • the party receiving the collateral has rehypothecation rights to use the cash collateral for other business activities (“fully cash collateralized”)
For an instrument such as a USD fixed-float interest rate swap under these CSA terms, market participants would be expected to value the swap by discounting the cash flows at the OIS rate.
In valuing certain collateralized derivatives, entities should assess whether OIS discounting is appropriate. Some of the questions to consider include:
  • What is the principal market?
  • What are the implications to end users?
  • What are the implications beyond collateralized derivatives?
  • Which transactions should be valued using OIS discount rate, considering different collateral terms across different credit support annexes?
  • How the determination of discount rate should be documented?
  • What modifications to systems and processes may be necessary over time? Principal market for derivatives

Because fair value is based on the exit price, not the transaction price, entry price, or settlement price, the fair value of a derivative is the price at which a novation transaction (i.e., when a derivative is transferred to a new counterparty that “steps into the shoes” and assumes the contract) would occur. In markets in which transfers of derivative instruments are uncommon, transaction price, entry price, prices used in margin calls, or settlement prices are sometimes used as data points in estimating an exit price. A reporting entity should take into account the characteristics of the asset or liability that market participants consider when pricing the asset or liability at the measurement date.
To assess exit price, a reporting entity should determine the principal market, the market with the greatest volume and level of activity for the asset or liability to which the reporting entity has access. Generally the principal market is the one where the reporting entity normally would enter into a transaction to sell the asset or to transfer the liability, but it may not always be the case. If that is not the case, the determination of fair value may require consideration of the pricing methodology used in another market. For further discussion of using data from markets other than the principal market, see FV End users

Discounting derivative cash flows using OIS may represent a change in practice for non-dealer end users. Many valuation systems used by end users continue to use LIBOR-based discounting in their derivative valuation models as a default setting. However, many systems and service providers are now supporting OIS discounting.
Based on the guidance in ASC 820, which requires the consideration of market participant behavior in the principal market when determining fair value, valuations derived using LIBOR-based discounting for certain products transacted under certain terms may no longer be representative of fair value.
Also, there may be diversity in practice in the valuations that major derivatives dealers provide to their customers. While many are still based on LIBOR discounting, some may be based on OIS. We suggest that end users evaluate what they receive. Implications beyond collateralized derivatives

The changes to market conventions may have broader implications than discounting. Because of the increased acceptance of OIS discounting for many collateralized transactions, market conventions on how certain reference instruments are quoted in the market have changed. For example, at-the-money (ATM) US dollar interest rate swaps (those with a mid-market price of zero since the present value of the LIBOR floating leg is equal and opposite to the present value of the fixed leg) are now typically quoted with an underlying assumption that the positions are collateralized. As a result, mathematical methods, such as bootstrapping, used to derive expectations of forward LIBOR rates from these instruments should be adjusted/refined to recognize the fact that the par swap rates are quoted assuming LIBOR floating cash flows and OIS discounting of the fixed and floating legs.
These refinements will affect the projected cash flows on all transactions indexed to LIBOR, and the discount rate to be applied to those instruments for which LIBOR is considered to be the appropriate discount rate. They also affect the way that market participants derive other market inputs, for example, swaption volatilities or tenor-basis curves, from market instruments. Transactions to discount using the OIS rate

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. Documentation

Reporting entities should document their assessments of the appropriate valuation basis to be applied to each class of derivative transaction. In some cases, the prevalence of OIS is clear; in others, reporting entities will need to exercise judgment as to which discount rate is appropriate. Documentation should include the evidence and rationale supporting the conclusions made.
Given the continuing level of change in the market related to derivative pricing, reporting entities should implement appropriate procedures and controls so that their valuation approach and the related documentation and disclosures are periodically updated and remain consistent with current market practice. Modifications to valuation systems and processes

Though vendors have been enhancing derivative valuation systems, not all systems may be able to differentiate between collateralized and uncollateralized derivatives or portions of derivatives. There may be a need to “bucket” derivative transactions with different characteristics in valuation systems to use different inputs for valuation. In addition, systems may need to be designed to apply different discount curves within the same currency (e.g., LIBOR for uncollateralized US dollar swaps and OIS for collateralized US dollar swaps) or apply one curve to project cash flows and a different curve to discount those same cash flows (as would be required in a LIBOR-based collateralized swap discounted using an OIS curve).
Also, systems and processes may need to change with respect to how data is derived from reference instruments that may have changed as a result of the migration to OIS discounting, and how transactions and associated CSA terms are considered in the valuation process.
In addition, the complexity of the product may affect the timing of when system capabilities may be available to support OIS discounting. For example, it may be possible to value interest rate swaps on an OIS discounted basis once the system has the ability to derive and apply LIBOR and OIS curves. The pricing of options on an OIS discounted basis may require the development of additional functionality to support the derivation of other inputs, such as volatility surfaces, in a manner consistent with the OIS discounting assumptions.

6.7.2 Funding valuation adjustment

While most major dealers agree that discounting based on the CSA is generally appropriate for collateralized derivatives, the consensus regarding the appropriate funding (and therefore discount) curves to be used in the valuation of uncollateralized derivatives or portions of derivatives subject to CSAs (e.g., those with non-zero posting thresholds that leave some part of the position uncollateralized) is at a less developed stage. There are a number of market participants considering if and how to incorporate a funding valuation adjustment (FVA). An FVA is an adjustment to fair value representing an institution’s cost of funding when it trades and hedges derivatives, whether positive or negative.
Risk magazine described FVA in 2011; we believe their explanation is still one of the more helpful.

Risk magazine February 2011, pages 18–22

When a dealer is in-the-money on the client trade, it would have to post collateral to its hedge counterparty, and would therefore need to borrow money from its internal treasury, which is a funding cost. … On the flipside, if the dealer is out-of-the-money on the client trade, it receives collateral from its hedge counterparty, and if the collateral is assumed to be rehypothecable, the dealer should be able to lend that collateral to its treasury, which is a funding benefit.

6.7.3 Accounting for changes in market participant assumptions

Valuation approaches and techniques should be applied consistently. Changes in valuation techniques or assumptions are appropriate if the result is equally or more representative of current fair value. Revised fair value measurements resulting from a change in valuation technique or its application are accounted for as a change in accounting estimate.

6.7.4 Summary — changes in market participant assumptions

OIS and FVA illustrate that even when the market participants in a given market haven’t changed, pricing methods continue to evolve. Assumptions should be monitored and potentially updated in determining fair value. As such, preparers should have a process for re-evaluating the assumptions used in their own valuations. Further, they should robustly document their conclusions as to what assumptions market participants would use, the observability of those inputs, and their level in the fair value hierarchy.
Reporting entities should closely monitor this topic for current developments.
LIBOR and reference rate reform
Regulators and industry bodies have proposed and agreed on new interest rate benchmarks to replace LIBOR rates that are anticipated to no longer be published or supported for certain rates past the end of 2021 and for all others after June 30, 2023. These new Risk Free Rates will be broad reaching across all industries that use or invest in interest rate linked products, and affect a comprehensive set of financial instruments including fixed income securities, loans and derivatives. The discontinuation of LIBOR may affect the functioning, liquidity, and value of these investments. For instance, contracts that do not contain fallback language may become less liquid and/or change in value as the discontinuance date approaches. The decrease in liquidity could affect the valuation and levelling of these investments within the fair value hierarchy. Please see PwC’s Reference Rate Reform guide for further information.
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