Mandated clearing of certain interest rate swaps and credit default swaps was recently completed with the addition of Category 3 participants on September 9. While the advent of mandatory clearing presents several challenges, one aspect that has garnered little attention is valuations.
OTC market participants, accustomed to valuations obtained from dealers, third parties or derived in-house, are now subject to central counterparty (CCP) valuations. Potential discrepancies between a CCP’s valuation and your own can be problematic, creating mismatches between internal profit & loss measures as compared to account values at clearing firms.
While major deviations in valuations are unlikely in plain vanilla, transparent derivatives, significant price differences may be observed on less liquid or exotic derivatives. Lack of consensus about a particular derivative’s value requires heightened understanding of the inputs being used to calculate values and heightened knowledge about how those inputs impact a derivative’s price.
For instance, there is not much dispute about the value of a short-dated MSFT option. Indeed, reams of data are readily and freely available on MSFT listed options that provide market participants with a consensus view as to MSFT’s implied volatility surface, at least on short-dated options.
But a long-dated OTC MSFT option, or any other non-transparent derivative, is not as simple. The further out in time that we go and the less data points that we have to rely upon raise significant questions as to the derivative’s value. What is the appropriate dividend to assume? Which interest rate should we use? What is the proper implied volatility? The answers to such questions are somewhat subjective and greatly impact the value of the option.
The move towards centralized clearing of OTC derivatives is a positive step for the industry and should help to mitigate systemic risk. And CCPs have appropriately started with the most liquid and transparent OTC derivatives. But as the industry moves beyond liquid OTC derivatives, important valuation challenges are likely to emerge on more exotic structures. The industry needs to address these challenges sooner rather than later.
For more information on new valuation procedures and current methodologies, register for FTF’s complimentary webinar, The Buy Side Takes On the New Age of Derivatives Valuation taking place on September 25th at 11 a.m. ET/10 a.m. CT.