AFGAP PRMIA– April, 5th The impact of funding liquidity on market products valuation A new paradigm? Alexandre Rameh The impact of funding liquidity on market products valuation A new paradigm? Alexandre Rameh AFGAP PRMIA

AFGAP PRMIA– April, 5th A paradigm shift Towards a new paradigm:  How risk free are the sovereign bonds?  How liquid is the interbank money market?  How homogeneous are the major banks short-term funding costs?  How liquid are off-shore currencies?  How important is the collateralization impact on derivatives pricing?  How accurate are models assumptions?

AFGAP PRMIA– April, 5th Agenda  A paradigm shift  Credit Risk  Funding Liquidity Risk  Collateralization of market products  Funding a collateralized deal  From a market point of view  The real life  The risk-oriented approach  From an ALM point of view  Assessment of the liquidity adjustment  One IRS: the stand alone liquidity adjustment  Two IRS: the marginal liquidity adjustment  A book of OTC…  The approach challenges conventional wisdom

AFGAP PRMIA– April, 5th Towards a defaultable sovereign debt  The old paradigm:  The sovereign bonds rates of return were considered as Risk-Free  The government can perpetually increase its taxation rate  The government can increase its debt nominal High discrepancy between sovereign funding costs

AFGAP PRMIA– April, 5th Towards costly interbank liquidity  The old paradigm :  The interbank short-term funding liquidity is infinite (~“cost-free”)  The BOR-OIS spreads term structure was flat and close to zero  Swap rates from different tenors were quite similar High funding liquidity premiums between different Libor € tenors Libor - OIS

AFGAP PRMIA– April, 5th Towards an heterogeneous interbank market  The old paradigm :  The interbank short-term funding costs were considered as stable within the panel banks  The contributions were in a few bps range  BOR term-structure was a good proxy for any bank Short-Term funding cost High discrepancy between panel banks short-term funding costs

AFGAP PRMIA– April, 5th Towards liquidity pricing  The old paradigm:  The interest rate Zero-Coupon curve was used as the funding curve of any bank and was calibrated on:  Libor quotes for the ST part of the curve  Swap (VS 3Mth) quotes for the MLT part of the curve Funding liquidity premium Different swap curves depending on the tenor rate + The unsecured funding curve is different from one bank to the other + Many curves depending on the collateral for secured trades

AFGAP PRMIA– April, 5th 2012 The new paradigm -8- Consequences:  Sovereign bonds are not risk-free anymore => Reliance on interest rate derivatives markets to benchmark long-term interest rates  Funding (even short-term) is costly, this cost is different from one bank to the other and resilience over time is questionable => Increasing cost to secure funding on long term horizons  Assuming no reliance on the Central Bank and illiquid credit lines markets, the funding liquidity risk can only be hedged through term funding Above points should be taken into account when pricing market products:  The BOR-OIS spread has been addressed in different academic papers  The Bank funding liquidity costs term structure VS the 3Mth curve should be taken into account “How to include funding liquidity in collateralized market products valuation?” Knowing that sometimes you cannot borrow, no matter the price…

AFGAP PRMIA– April, 5th Agenda  A paradigm shift  Credit Risk  Funding Liquidity Risk  Collateralization of market products  Funding a collateralized deal  From a market point of view  The real life  The risk-oriented approach  From an ALM point of view  Assessment of the liquidity adjustment  One IRS: the stand alone liquidity adjustment  Two IRS: the marginal liquidity adjustment  A book of OTC…  The approach challenges conventional wisdom

AFGAP PRMIA– April, 5th 2012 From a market point of view  The market assumptions concerning collateralized deals:  The cost of funding the deal equals the Euribor 3Mth  The collateral is remunerated on an EONIA basis  The cost of carry is equal to E3Mth-EONIA  The collateralized deals cashflows should be discounted with an OIS curve Paying the BOR- OIS spread The graph gives a simulation path of the collateral posted (i.e. Minus the Present Value of the Fixed leg payer swap under the perfect collateralization assumption) for a 10Y ABB, EURIBOR3M payer swap. Receiving the BOR-OIS spread -10-

AFGAP PRMIA– April, 5th 2012 The real life  Different Posted Collateral Simulation Path: -11- (x Nominal) The graph gives different simulation paths of the collateral posted (i.e. Minus the Present Value of the Fixed leg payer swap under the perfect collateralization assumption) for a 10Y ABB, EURIBOR3M payer swap.

AFGAP PRMIA– April, 5th 2012 The real life - 2  The risk for the bank is to be unable to fund the future margin calls at Euribor 3Mth (rollover risk)  The only way to hedge funding liquidity risk is to term fund the position  The collateral demand of a deal can potentially be infinite  The collateral needs can only be term funded with a given confidence interval The graph gives the forecast of the Collateral at Risk with a given confidence interval. A € 1bn 10y swap requires a € 100mm liquidity reserve (at the 90% confidence interval) Liquidity buffer with a 90% confidence interval -12- (x Nominal)

AFGAP PRMIA– April, 5th 2012 The risk-oriented approach We will assume that the part of the buffer not used as collateral is lent at 3 month Euribor -13- (x Nominal) Principal to be Term Funded for €1bn Fixed Payer 10Y swap EONIA?? ~ + 2bps

AFGAP PRMIA– April, 5th 2012 The ALM point of view  There is a need to term fund the liquidity buffer in order to be able to fund the deal at Euribor 3Mth  Consequently, the funding liquidity costs against the 3Mth curve should be taken into account  As two banks have different funding liquidity premiums, their prices will not be the same!! The cost of carrying the deal is much greater once the funding liquidity position is hedged Paying the BOR- OIS spread Receiving the BOR-OIS spread Bank funding liquidity premium -14- (x Nominal)

AFGAP PRMIA– April, 5th Agenda  A paradigm shift  Credit Risk  Funding Liquidity Risk  Collateralization of market products  Funding a collateralized deal  From a market point of view  The real life  The risk-oriented approach  From an ALM point of view  Assessment of the liquidity adjustment  One IRS: the stand alone liquidity adjustment  Two IRS: the marginal liquidity adjustment  A book of OTC…  The approach challenges conventional wisdom

AFGAP PRMIA– April, 5th 2012 The stand alone liquidity adjustment  We take the example of a 10Y Fixed leg payer/receiver interest rate swap:  We assess the Collateral at Risk (CaR) with a certain confidence interval (90%) -16- Asymmetry between fixed payer and receiver Swap rate = 2.4%

AFGAP PRMIA– April, 5th 2012 The stand alone liquidity adjustment - 2  From the CaR forecast:  We assess the liquidity buffer  We assess this buffer Present Value  Dividing by the Swap Level, we have a liquidity spread equivalent -17-  On the pricing date, we approximate the funding liquidity premium term structures of bank A, B, C and D with a logarithm function:  We give the four banks funding liquidity premium parameters:  From which we derive the four banks corresponding spreads (i.e. the buffer PV/Swap level): BankABCD Fixed leg payer adjustment spread (bps) Fixed leg receiver adjustment spread (bps) BankABCD a (bps) b Average premium (bps)

AFGAP PRMIA– April, 5th 2012 The marginal liquidity adjustment  We now deal with two swaps:  IRS VS BOR 3 months (5Y and 10Y)  We show the stand alone CaR: -18-

AFGAP PRMIA– April, 5th 2012 The marginal liquidity adjustment - 2  Let us assume there is only one fixed payer 10Y swap in the book and that we want to add a second deal:  We want to show the marginal effect when entering a fixed payer/receiver 5Y swap Y floating payer has a negative marginal impact because it mitigates the directional position of the collateralized book 5Y fixed payer marginal and isolated contributions are the same

AFGAP PRMIA– April, 5th A book of OTC…  We will compute collateral needs from the net MtM Book value (equivalent to LCH practice)  It is interesting to stress that this collateral could be something else than € cash  For a Cross Currency Swap, the volatility of the exchange rate leads to a more important funding liquidity effect:  The methodology can be generalized to a book of OTC with different underlying market products  The collateral needs will be assessed on the whole book  One deal will have a marginal liquidity adjustment depending on the book structure  Funding liquidity effect when synthesizing currency A borrowing currency B and entering a Cross Currency Swap  Collateralization in currency A or B?  20% buffer size for a 5y EURUSD CCS ~25bps annually buffer cost CSA OTC with negative PVs Collateral received LIABILITIESASSETS CSA OTC with positive PVs Collateral posted

AFGAP PRMIA– April, 5th 2012 The approach challenges conventional wisdom “Received collateral can be used to fund the posted collateral”  That’s why we assess the net collateral demand of a book (posted – received) taking into account the correlation between different market products “One can sell the position if the liquidity demand is too high”  This is equivalent to selling the position at the worst time, when the PV is very negative -21-

AFGAP PRMIA– April, 5th 2012 “Collateralization mitigates the deal cash flows so that the funding requirement is lower for collateralized trades than for uncollateralized ones”  This is true if the spot price follows the forwards (on average)  The problem is precisely the impact of a market shift on the deal cashflows  Collateralization forces to immediately fund the Value coming from a market move The approach challenges conventional wisdom Expected Swap CF without collateralization Uncollateralized IRS CF to be added after a market shift Collateralized IRS CF to be added after a market shift Collat Market Shift

AFGAP PRMIA– April, 5th 2012 Collateral Funding is also an Asset & Liability Management issue  The management consequences concern both:  The management of the funding position of Fixed Income activities,  The management of the funding adjustment for Interest Rate Swaps used to hedge Interest Rate Risk.  The collateral needs should be computed at the book level, consequently: Management consequences The deal price depends on: 1°/ The bank ’ s funding curve 2°/ The bank ’ s funding liquidity policy 3°/ The bank ’ s book structure  This approach can be generalized to other products:  Synthetic funding of off-shore currencies with collateralized CCS,  Delta-hedging of an equity option…  Despite the price of the hedging strategy, the funding liquidity hedging strategy should be initiated at inception of the deal…

AFGAP PRMIA– April, 5th Take Away From This Presentation  Funding Risk needs to be considered in managing and pricing derivatives, be they collateralized or not  This requires modifying the usual method that consists in spreading discount rates, and calls for building up a specific liquidity buffer… … whose cost should be considered at deal level, or as a reserve-like mechanism  Definitely, there is no longer single “market value” since it depends on each bank funding cost, funding policy and book composition

AFGAP PRMIA– April, 5th Thank you… Q & A