Alae Iacta Est (2)
alea iacta est (actually almost "est")
The results of "The Final Parameters Consultation" have been published. The winner is "historical median approach over a five-year lookback period" with "two banking day backward shift adjustment period". The exact meaning of this has been subcontracted to Bloomberg. This clarifies that the "final" adjective in the consultation name was related to the consultation, not to the parameters.
Clearly ISDA did not listen to my suggestion of publishing the results when markets are closed and announcing the publication date in advance. My suggestion was made in order to limit the impact of non-public material information. But I guess that those issues are not deemed important in this circumstance. Probably the lawyers don't understand the impact of information on derivative valuation. Let me remind you that present value in s is
Ns E[(Nt)-1 Pay-offt | Fs]
It dependents strongly on pay-off (what is changed by the fallback) and the filtration (the information available).
Thank you to a fellow Belgian in joining me in responding to the consultation... That makes it two of us.
In the results report, many respondent are classified as "unresponsive", like in
Them: Choose between the devil and the deep blue sea.
Me: I don't want any of them!
Them: You are unresponsive!
Me: Here is my rational and extensive answer why both are bad.
Them: Thank you, we classified you as unresponsive and threw your explanation away.
With this selection of median over a 5-year lookback period, we can now stop any pretence that the fallback method is a fair replacement of LIBOR which tries to reduce the value transfer. Derivatives values are computed by expectations, i.e. means. What the F*** is this median number doing in my value? Spread will be used over the next 50 years, in which sense the last 5 years with very mild credit risk and orgy of liquidity provided by central banks is representative of long term behaviour?
Consistency is critical or very important for 70% of the respondent, nevertheless, the responses themselves are not consistent:
* Use median 55/90 - 61% Yes
Exclude the outliers: 44/90 - 49% No
Median is, by definition, the exclusion of all outliers, actually it uses only 1 or 2 data points. Do the answers indicate that respondent don't understand what median means (pun intended)?
* Backward shift on the period: Majority: Yes. On which period: majority: we don't know!
As indicated previously, those nested consultations do not provide a global coherent solution. Each layer ask for partial answers and the next one invents workarounds because the partial answers do not work. Method look like the old dictatorial method: 1) ask a question 2) when you have the answers, decide what the question means.
The original consultations were about a Compounded Setting in Arrears applied to the relevant IBOR tenor. As this final consultation introduces a shift and a potential calculation period (I still don't know what the calculation period exactly means), the proposal is not the IBOR tenor anymore. If consistency was paramount, the introduction of the new period would invalidate the results of the first two consultations. They should be run again, this time adding that shifted calculation period in the options.
But consistency does not appear to be important in this political game.
Hopefully the financial institutions trade derivatives with a clear end-to-end business model.
Another short fiction (after the protocol short fictional story): How to use derivatives like a fallback consultation. We trade a derivative, then we discuss what we will use it for, then on the payment date, we ask what back office function we need for it, when one payment has been done we notice that derivative are more complex than the marketing brochure indicated, so we decided that the payment for the month of August will not be done because we are on holiday, we ask our counterparties if this is a problem, we don't read the answers as we are on holiday.
"The spread adjustment will be applied to a compounded in arrears rate with the applicable calendar to be determined and announced by Bloomberg prior to implementation." So it seems it is Bloomberg that decides the actual spread methodology!
Reading the document I still don't understand how the "compounded setting is arrears with historical median" will actually be computed. The fallback will be a 2-day shifted period, which period is not clear, which 2 days is not clear, to which products it will apply to is not clear. The historical median spread, will it be computed on the IBOR period or the calculation period (which calculation), with or without 2 days shift?
By the way, even this T-2 shenanigan is not enough to obtain an achievable fallback for IMM swaps. Even with a T-2 adjustment, you still have to pay an unknown amount on some payment dates. Hopefully you don't have IMM swaps in your book, because they are considered as exotics, not worth ISDA time and there is no ready-made fallback for them.
A more efficient method to decide the spread would be: select 6 spreads spaced by 5 bps. Write those numbers on a dice and throw the dice. Use the spread appearing on the upper face of the dice. That would have justified the "alea" in the title of this post as well as the actual process. Obviously don't ask if the dice is fair, who selects it and who throws it, those are not a meaningful questions!
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