independent valuations : a step by step process

Valorisation des Produits complexes
JJ Mois Année
Un enjeu pour l’industrie des dérivés
EIFR, Mars 2012
Laurent Thuillier, Head of Asset Servicing,
Société Générale Securities Services
AGENDA
INTRODUCTION_ A NEW WORLD
01_ INDEPENDENT VALUATIONS : A STEP BY STEP PROCESS
02_ IMPACT OF THE FINANCIAL CRISIS ON VALUATIONS
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INTRODUCTION
OTC’s
: A growing market
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INTRODUCTION
Instruments
IR : Asset swap, IRS, CCS, FRA, Swaption, Inflation swap, Bond option Cap/Floor, Collar, Ascot
Fx : Fx fwd, Fw swap, FW option, NDF, NDO
Credit : CDS, CDX, Synthetic CDO’s, NtD
Equity : Variance swap, Volatility Swap, TRS, ELS, Equity option, Equity basket swap, Equity basket
swap, Equity basket forward, index option, Dividend swap
Commodity : Swap, Options, swaption, index swap
Exotics / Structured products : Hybrids, barriers, cliquet, callable, switchable, ratchet, snowball…
Securitised products : ABS, MBS, cash CDO’s…
OTC’s encompass a huge number of instrument types across all asset classes
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CHAPITRE 02
INDEPENDENT VALUATION :
A STEP BY STEP PROCESS
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INDEPENDENT VALUATION : A STEP BY STEP PROCESS
Valuation process
Valuation Process : a four step process
• Instrument specifications : payoffs, conditional cash flows, risk factors
• Market parameters management : acquisition and validation of market data
• Price calculation and sensitivities : models, numerical methods, calibration, IT framework :
pricing libraries, grid computing
• Output control : benchmarking valuations / models, discrepancy analysis
Associated risks
Bad specification
Market data unavailable or corrupted : « Garbage in, garbage out »
Model risk, « Overfitting », numerical error, technology failure
No benchmark with counterpart’s valuations
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INDEPENDENT VALUATION : A STEP BY STEP PROCESS
_OTC’s valuation process
Trade characteristics
Valuation
Model
Market data
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INDEPENDENT VALUATION : A STEP BY STEP PROCESS
Trade management
Getting the trade in the system
• Can be automated for vanilla trades such as IRS, CDS, or FX options
• Cannot be automated for structured / bespoke products : the only reliable information is the
term sheet
Managing the product life-cycle
• Trade amendment
• Nominal increase / decrease / partial or full termination
• Fixing resetting
Managing events
• Corporate action
• Trigger events (barriers …), exercises
• Credit event
Life-cycle of OTC’s is complex and has direct impact on the quality of the
valuation function
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INDEPENDENT VALUATION : A STEP BY STEP PROCESS
Pricing Models
Each asset class has its own dynamics
• Inflation needs seasonal adjustments
• Interest rates tend to exhibit mean-reverting behaviour
• Equity dynamic needs to take into account dividend forecasts
For OTC vanilla
• Models are simple and used by all market participants
• Numerical methods : mainly closed formulas no numerical errors
For Exotic and structured products
• Models
can by fairly complex and sometimes no consensus for market participants
• Numerical methods are time consuming : MC simulations, PDE, Trees… Numerical errors
need to be monitored
• Models need to be calibrated
Financial engineering expertise is required to develop and maintain those
pricers
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INDEPENDENT VALUATION : A STEP BY STEP PROCESS
_Market parameters sourcing
Data sourcing :
• Usual providers for yield curves, fixings…
• Consensus for dividends, CDS curves…
• OTC brokers for equity volatility or swaption cube…
• Investment banks for exotic parameters such as correlation
Data Calculation :
•Some data can be calculated. It is always better to use “implied data” when possible
Market trend :
• Access to market data is getting more and more difficult
• Cost of market data is increasing
Market data is the corner stone of the valuation process
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INDEPENDENT VALUATION : A STEP BY STEP PROCESS
_Market parameters management
Multi-sourcing hierarchy management
Data validation : cleaning / sanity check
•
Basic controls : D/D-1 discrepancy analysis, outliers, multi-sources consistency…
•
Advanced controls : Check for data arbitrage
Complex data re-engineering
•
Smoothing of volatility surface if the surface is arbitrageable
•
Nearest correlation matrix computation
Market data quality check must be implemented and automated
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INDEPENDENT VALUATION : A STEP BY STEP PROCESS
_Volatility surfaces and calibration
Calibration process is done to make sure models calculate accurately vanilla
instruments for which prices are available on the market
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INDEPENDENT VALUATION : A STEP BY STEP PROCESS
_ Reconciliation process
Valuation is only the first step
In order to analyse discrepancies with the counterpart price it is necessary to compute :
• Price and sensitivities
• Expected cash flows
• Relevant implied parameters : call probability, barrier hitting probability
Discrepancy sources
• Rarely models if methodological watch is performed
• Market data can be a source of discrepancy
• Bad knowledge of market practices such as calibration, hedging exotic parameters can be a source
of discrepancy as well
Reconciliation with counterparts valuations is key in the process
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INDEPENDENT VALUATION : A STEP BY STEP PROCESS
_Credit risk
Before the credit crisis Investment banks didn't price credit risk in structured product valuation
Since Lehman collapse the market is pricing this risk
•
It will lower the valuation of the note if the issuer has a spread over Libor positive
•
Getting issuer's spread is complex : CDS Market, Bond Market...
•
It can become the main risk factor of the product. Large spread can annihilate the value of the
instrument
Since Lehman collapse credit risk mus be priced
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CHAPITRE 01
IMPACT OF FINANCIAL CRISIS ON DATA
AND VALUATIONS
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IMPACT OF THE FINANCIAL CRISIS ON VALUATIONS
Financial crisis : Basic spread widening
10 Y Eur3M /Eur6M basis spread between 2004 and 2011
• Euro swap rate
on Euribor with
different tenors
cannot be discounted
anymore with
the same curve
Data Management
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• Consequently
many curves had to
be built and maintain
in the system for each
currency
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IMPACT OF THE FINANCIAL CRISIS ON VALUATIONS
Financial crisis : Equity volatility increase
V2X index = short term expectation of volatility on SX5E
•
The fast-change in
volatility forecast led
to less robust calibration
processes
•
More valuation
discrepancies to analyse
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IMPACT OF THE FINANCIAL CRISIS ON VALUATIONS
_Financial crisis : Cross currency basis spread
5 Yr EUR/USD Basis Spread
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IMPACT OF THE FINANCIAL CRISIS ON VALUATIONS
Financial crisis : CDS Spread
5Y CDS Spread on major EU countries
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IMPACT OF THE FINANCIAL CRISIS ON VALUATIONS
Financial crisis impact on data and valuations
•
Lack of liquidity. Increase of price discrepancies among market participants
•
Increase of underlying volatility / price volatility
•
Equity correlation increase due to simultaneous drop of shares
•
Counterparty risk management : CDS spread, cash spread ?
•
Discount / Forward curves has to be rebuilt : liquidity premium too high in libor > 3M
•
Futures / FRA has to be taken into account when available
•
Management of many curves (V3 3M, VS 6M…)
•
Model Calibration issue
•
Some market Data not unavailable
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