Financial fiction: zero rate collateral

Episode 2: Zero rate collateral

There is certainly a push for more standardisation of financial products and their collateral terms – Credit Support Annexe (CSA) and margining process in particular. One particular discussion is around the CSA collateral remuneration and its equivalent Price Alignment Interest (PAI) used by Central Counterparts (CCPs). In the current standard terms an overnight rate (Fed Fund, EONIA, etc.) is paid in the currency of the trade in most cases. One potential solution to simplify the term of the CSAs, that I propose as my next fiction, would be to pay interest at a rate of 0 on the collateral. This would certainly simplify the computation of the interest part of any variation margin.

This proposal would align collateral and CCP process to the margin process used for exchange-traded futures. The amount paid as variation margin on futures, on OTC and on cleared trades would not include any interest any more and would be in line. As a secondary benefit, the overnight indexes fixing importance would have the role it should not have lost as an indicator of the economy and not as a main part of the economic process.

Suppose that there is a continuous perfect collateral, a collateral paid in cash in the currency of the instrument and a rate paid on the collateral of 0. From a valuation perspective, the valuation under collateral would become similar to the margining on futures: the difference of value with the previous valuation is exchanged and no interest is paid on that amount. The general futures price process theory, or the multi-curve and collateral framework as described in Chapter 8 of the book, both apply in this case.

What is the value of an Ibor coupon with CSA at rate 0? The answer in term of futures is easy (if we forget about notional and accrual factor)

PV0 = 1 - Φ0
with Φ0 the price of the STIR futures in 0.
Note that the fact that the coupon pays at the end of its actual period has no impact anymore on the valuation. The quote (to use the terminology of the book) is known at the fixing date of the Ibor index and from that date on, the required collateral is known and transferred. The payments in advance or in arrears have the same quote. Maybe there would be a legal distinction between the amount paid as collateral and the amount paid as coupon, but if we ignore that legal distinction, from a pure cash flow exchange perspective, everything is exchanged as soon as the cash flow is known; present value equals futures value (pun intended).

The general collateral principle is still valid: a promise to pay tomorrow is fulfilled by paying today the discounted forward value and adapting the amount up to the final payment. The difference here is the discounting is done at a rate of zero and the fact that no adaptation is required after the last fixing.
There is no convexity adjustment due to the difference in timing of the payments between futures and cleared swaps. This is a world where convexity adjustment becomes an exotic feature for non-standard collateral practice, not a vanilla characteristic of every curve calibration.

It is important to clarify that zero-rate collateral is not equivalent to zero collateral. The collateral is paid, there are cash-flows every day. The cash flow paid every day does not include any interest for previously paid cash flows. What has been paid is paid and we do not adjust the payment subsequently by added some interest to it. That may seems an extravagant proposal, not receiving interest on cash deposited. Looking at it from another point of view, in the futures market, which is probably the most liquid and oldest derivative financial market, used by banks, hedge funds, asset manager, pension funds, and corporates, nobody complains about the absence of PAI (or interest on previously paid profit). The usage of interest on collateral is more an habit (or maybe addiction?) than a fundamental economic necessity.

In interesting to note that the EONIA rate, which is computed in the afternoon of the starting date of the overnight period, is not publicly available anymore on a same day basis; it is available only on the next day. If a figure is used for general process and the regulator forces in some way market participants to use that process, the least we could hope from the regulator is to insure the minimal transparency and make sure the figures are publicly and fee-free available to all. To my opinion, this is a part of the "fixing scandal" that regulators have not addressed properly, if indexes are used for public processes, and anything mandatory by regulator rules should be considered as public, all the relevant related information should be public. The relevant information refers at the very least to the index value as soon as known and its full historical data. In the absence of public availability of the figures used currently, the proposal of a public and transparent rate a zero (0) would be a good improvement.


When fiction becomes reality

In one of my recent blogs, I proposed the first episode of a series in Finance Fiction. The blog presented packs and bundles options as an addition to the interest rate exchange-traded offering; it was based on ideas initially proposed in early 2013 in a paper on STIR futures and presented in Section 7.8.6 “Ceci nest pas une option” of the book.

It turns out that either someone read the paper and the blog and took it for reality or the ideas proposed were not so fictional. CME has announced it will start offering bundle futures(1) and bundle futures options from September 2014.

I’m not an expert in legal matters: Can an author claim copyright on reality when reality copies the author’s fiction?

The quote I used in the original paper on the subject (and in the book) was
Messieurs les Anglais, tirez les premiers !
Attributed by Voltaire to the (French) Comte d'Auteroche at the battle of Fontenoy, 1745
and I continued with
The XXIst century corporate warfare is probably not as courteous as the XVIIIth century real warfare and there will probably be no similar offer, but the question is open: who will shoot first?
Now we have the answer, the first to shoot are not English but American and they are based in Chicago.  USA did not exist as a nation when the Comte d'Auteroche spoke in 1745, so the absence of a similar offer to “Messieurs les Américains” is understandable.

Those new futures offer exposure to the same underlying Libor rates as the deliverable swap futures with same expiry and tenor. It seems that CME is creating competition for its own DSF through the new bundle futures. One of the reason for this apparent duplication is probably that in term of quotation mechanism and option strike the two instruments are quite different. The bundle futures contract is quoted in rate (more precisely 1-rate) and the current CME’s DSF contract is quoted in present value. The rate dimension is more familiar to the swap and STIR futures users, the present value dimension is more familiar to bond and bond futures users. Moreover the present value quoted DSF are not well suited for options on futures that would compete with swaptions.

Some of the points mentioned above may seems a little bit cryptic. The reason I'm not more explicit at this stage is that my thoughts on those points are the subjects of subsequent episodes of the Finance Fiction series. Any good series episode finishes with a teaser to the next episode, I don’t see any reason for not using the same technique here. The titles of some of the next episodes are:
  • Collateral with zero-rate
  • Risk based swap futures
  • Options on swap futures
In the last years, two of my fictions had a rapid turn-around into reality(2): the multi-curve framework initial paper was published in July 2007 and became the base of a standard in the subsequent crisis years; options on bundles (and packs) of STIR futures were proposed in March 2013 and will become an exchange-traded product in September 2014.

Given those precedents, I hope that some of my forthcoming fictions episodes will also become reality. If you are interested by my services related to future-proof futures design, I’m available for consulting :)

(1) Bundle futures is a new term invented by CME for the occasion. It is financially equivalent to bundles on futures but a bundle futures is traded as unique contract and deliver into the underlying individual STIR futures only on expiry.

(2) For obvious marketing reasons, I do not highlight the proposals that failed to materialise, like options on composition or OIS swaption.

Financial fiction: Pack's option

Finance fiction

After numerous conferences on the impact of regulation and the new market structure on quantitative finance, it’s time to start thinking about the impact the quants can have on regulation and the market structure.

The book not only covers theoretical considerations about the foundations of a multi-curve framework, and practical considerations about liquid instruments, it also contains directly or indirectly some "finance fiction" episodes where non-existent instruments or practices are described.

The reason to introduce such fictions in a non-fiction book is that the market is changing and is largely incomplete. Instruments that were completely redundant in the past are now becoming nice-to-haves or even must-haves. Changes in regulatory treatment, movement to futurization, generalisation of collateral and margining practices have created a moving ground. The financial landscape is moving; I try to guess some of the potential new characters.

After speaking at numerous conferences where the topic was something like "impact of the crisis/regulation on quantitative finance", I would like to start a new trend on "impact of quants on regulation/market structure". The indirect goal of those episodes is to influence changes in the direction of a more complete offering or simpler rules.

My first episode in that trend is:

Episode 1: Pack's options

Packs and bundles

A futures pack is a block of four consecutive STIR futures (1st to 4th, 5th to 8th, etc.). The packs are colour-coded, from the first to the tenth pack: white, red, green, blue, gold, purple, orange, pink, silver, and copper. The packs are traded as such on different exchanges; one trade creates positions in the four underlying futures. A futures bundle is a block of the first packs. A n-year bundle is a block of the first n packs, i.e. the block of the 4*n first futures.

Packs and bundles are traded on CME in USD and on LIFFE (and planned at NLX) in EUR and GBP.

A single futures contract is the exchange-traded equivalent of the OTC FRA; a pack is the equivalent (in terms of Ibor fixing involved) of a one year forward starting swap; and a bundle is the equivalent of a n-year spot starting swap.

Ceci n'est pas une option

New options on STIR futures have been added recently to the offering with mid-curve options now offered up to five years. Nevertheless the offering is still in some way incomplete. A single futures contract is equivalent to a FRA, a pack/bundle is equivalent to a swap. On the option side, an option on a future is the exchange-traded equivalent of the OTC caplet or floorlet. But where are the equivalents of swaptions and forward starting swaptions? This is certainly a missing instrument in the exchange-traded offering(1). It is not an option for traders to trade the equivalent of swaptions in the futures world.

Ceci n'est pas une pipe.
La trahison des images, René Magritte, 1928.

New option

Completing the missing offering could be achieved in different ways. Our suggestion for this episode is to create options on packs and options on bundles. To our knowledge none of these products are currently offered at any exchange. Given the push for more standardisation and exchange-traded products, the question is which exchange will be the first to offer such a product?

Messieurs les Anglais, tirez les premiers !
Attributed by Voltaire to the (French) Comte d'Auteroche at the battle of Fontenoy, 1745

The XXI century corporate warfare is probably not as courteous as the XVIII century real warfare, and there will probably be no similar offer, but the question remains open: who will shoot first?

What are the details of those options?

The options are characterized by an expiry date and a strike (denoted K below). The option is on a given pack or bundle (with n futures in the block) and can be of the call or put type. The option could be traded on a premium or continuous margin basis. As I personally prefer the margined options for futures, I describe here only the margined version. The options are traded in price(2). A settlement/closing price is computed every day by the exchange; usually it represents the price at the end of the trading period. The profit (today's price minus yesterday's price) is paid immediately by the short party to the long party (obviously if the numbers computed are negative, in practice the positive flow takes place in the opposite direction). This is a usual futures-style margin process.

On the expiry date, the call (resp. put) long party has the right (but not the obligation) to enter into a long (resp. short) position in the n futures underlying the pack/bundle. This is an all-or-nothing option; the exercise is for all the futures in the block; the exercising party cannot select which futures in the block are exercised and which are not. The futures exercised are obviously fungible with standard STIR futures. The price at which the futures are entered into is the same for all of them in the block and is K.

If we denote by Fi the price of the i-th future in the block, the pay-off can be written as
Sumi=1n (Fi- K)

Why a new product?

Given the inertia around any new product, especially in very standardised settings, we need a compelling reason for a new product.

Let me start with the non-compelling reasons. Those reasons are technical. The existence of a larger class of options, i.e. adding a pack's options to the futures, vanilla options and mid-curve options will enrich the calibrating instruments of models. This is important to price exotic options that depend on the correlation structure between LIBORs at different dates. Currently those options are not represented in the exchange-traded world.

But who needs exotics today?, I hear you ask. My answer is that new regulations are imposing exotic structures to standard products, like some path dependent caps and floors on mortgages, or timing adjustment on rolled deposits (LTRO), etc. One has to define "exotic": in the sense used here, it is not related to liquidity but a technical term meaning we need a dynamic model and a non-trivial numerical procedure to solve it. Enter into this category a lot of liquid products: bond futures (delivery option), FRA (FRA discounting), and change of collateral/margin. A lot of liquid products are, in the sense used here, exotic products.

The main reason for creating the new product is to fill a gap. The interest rate option market is important as very popular types of mortgages are fixed rate prepayable (the borrower has the option to repay his mortgage) or floating rate with some kind of cap/floor (potentially path dependent). A liquid exchange-traded market for options is useful. Currently that market exists only partially. Options on STIR futures are very short-term options of the cap/floor type, mid-curve options extend to underlying up to 5 years but are also very short-term expiry and on specific rates, not on a block of them. Offering options on packs and bundles would give more flexibility for hedging and expressing views. Options on bundles would be similar to swaptions and options on packs would be similar to options on forward starting swaps. The swaptions are the most liquid interest rate options in the OTC world. The reason of the liquid market on swaptions is also valid for a liquid market on the pack's options.

STIR futures are offered only to 10 years, with a lot less liquidity above 5 years. The interest on the pack's options would be mainly on the short to medium term sectors. For options on long-term rates (up to 30 years and maybe 50 years), another product would be required. But discussing that issue requires multiple new episodes, one for a "clean" swap future and one for the options on them.

And the pricing?

A technical discussion on how to price options on packs and bundles in a stochastic basis model is proposed in the book (Chapter 7, Section 8). In summary, in a Gaussian one-factor HJM with simple stochastic spread, the approaches used for swaptions and STIR futures with stochastic spread can be combined. If the products are becoming liquid, a model with smile dynamic would need to be developed, but that would be a non-fiction episode conditional to the realisation of the fiction.

(1) Some options on swap futures exist, but they are mostly illiquid. Some options on deliverable swap futures (DSF) may be added in the future, but for this the creation of a "clean DSF" is required. That in itself is another finance fiction episode.

(2) The term price for (options on) futures is a misnomer as the price is never paid; a term like "reference index" would be a better name. See also the introduction of Chapter 8 in the book for more on the subject.

Edit (13 August 2014): A slightly modified version of this blog appeared on OpenGamma's blog under the title: The Impact of Quants on Regulation and Market Structure.