Overnight index swap and integrated credit valuation adjustment discounting

Abstract

A new generation of interest rate modelling based on dual curve pricing and integrated credit valuation adjustment (CVA) is evolving. This new framework requires a rethink of derivative modelling from first principles and presents significant challenges for existing valuation, risk management and margining systems. Prior to the credit crisis, interest rate modelling was generally well understood. The underlying fundamental principles had existed for over 30 years with steady evolution in areas that were most relevant to options and complex products. Credit and liquidity were ignored as their effects were minimal. Pricing a single currency interest rate swap was straightforward. A single interest rate curve was calibrated to liquid market products and future cash flows were estimated and discounted using this single curve. There was little variation between implementations and results across the market were consistent. Following the credit crisis, interest modelling has undergone nothing short of a revolution. During the credit crisis, credit and liquidity issues drove apart previously closely related rates. For example, euro interbank offer rate (Euribor) basis swap spreads dramatically increased and the spreads between Euribor and euro overnight index average (Eonia) overnight index swaps (OISs) diverged. In addition, the effect of counterparty credit on valuation and risk management dramatically increased. Existing modelling and infrastructure no longer worked and a rethink from first principles had to take place.