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An Interest Rate Swap (IRS) is a versatile and widely used derivative that helps firms manage interest rate exposures, reduce borrowing costs, and restructure cash flows in a cost-effective manner. A vanilla IRS allows two parties, each with an identical notional amount, to exchange a future stream of fixed rate payments for a stream of floating rate payments. An IRS can also be structured to exchange payments in different currencies or exchange two streams of different floating rate payments. Utilized by corporations, governments, and investors, the importance of US dollar denominated IRS is underscored by their massive trading volume, with Euro-denominated volumes close behind.

“The calculations for pricing derivatives and measuring risk are becoming increasingly complex under regulatory reform. Collateral requirements and capital charges will not only transform the industry but change the day-to-day pricing of instruments and portfolios. In order to capitalize on these changes, derivatives traders need a flexible and highly accurate approach to risk measurement.” – Adam Sussman, Director of Research, TABB Group


VALUING AN IRS

Accurately valuing an IRS is key to unlocking their economic benefit. With an average swap size measured in millions of dollars, even a slight mispricing can seriously impact a swap trader’s P/L. Prior to the financial crisis; IRS valuation was straightforward, utilizing a process called bootstrapping to calculate discount factors for future cash flows from a risk-free yield curve. Since 2008, swap valuation has become significantly more complicated. This Insight discusses dual curve stripping, a relatively recent innovation that has quickly become the industry standard for accurately valuing swaps.

Firms traditionally used an interbank lending curve such as LIBOR for bootstrapping, assuming it to be a reasonable risk-free rate proxy. The 2008 failure of Lehman Brothers and the subsequent LIBOR rate-rigging scandal invalidated this assumption, forcing the financial industry to rethink their swap valuation and risk management practices. To mitigate counterparty risk associated with swap and other OTC derivative transactions, firms increasingly demanded collateral, specified in an ISDA agreement credit support annex (CSA).

In response to the 2008 crisis, central banks, including the U.S. Federal Reserve, provided unprecedented liquidity via their bank lending windows. In the U.S. this lending was based on the Fed Funds rate, utilizing short term Treasury Bills. These risk free assets became the industry standard for collateral maintenance on swaps contracts. Swaps traders began using discount factors derived from the overnight index swap (OIS) curve to value swaps. An OIS is a vanilla interest rate swap where the floating rate is calculated using the published effective central bank rate. Unlike LIBOR, overnight interest rates are determined based on actual transactions around target rates set by central banks. A number of currency-specific overnight interest rates are used for swap pricing. For example, dollar denominated swaps are based on the Fed Funds rate, while euro-based swaps utilize EONIA (Euro Overnight Index Average).

DUAL CURVE STRIPPING
While collateralization is a prudent risk management practice, it introduces new complexity to the swap valuation process. Parties on either end of a swap pay or earn overnight rates on posted collateral. But interest rate swaps are still largely negotiated using an interbank rate such as LIBOR. This requires a second set of discount factors to be derived in order to correctly value swaps, hence the term dual curve stripping.

While conceptually simple, dual curve stripping involves significant computational complexity and careful data management. Dual curve stripping uses bootstrapping to create separate interbank and OIS curves and then discounts the interbank curve using discount factors derived from the OIS curve. Dual curve stripping produces a non-zero initial swap value, so additional computation is required to solve for a zero premium at swap inception. The end result is a single curve suitable for accurately valuing IRS contracts based on the respective interbank rate and currency specified in the swap contract.

Accurate construction of the OIS and LIBOR curves involves assembling market prices from a variety of instruments, including cash deposits, swaps, and futures or forward rate agreements, prior to bootstrapping. This is because each instrument is only specified and traded for a particular time segment across a 30+ year curve. The intricacies of curve construction highlight the importance of having a data strategy in place that governs how data is used to support a firm’s investment process. A well-designed EDM that sources, validates and feeds the analytics calculation engine helps ensure that the right instruments and tenors are used when constructing curves.

WHY IS DUAL CURVE STRIPPING IMPORTANT?
Dual curve stripping is becoming an industry standard best practice. Regulations, including Dodd-Frank and EMIR, have made swap collateralization mandatory. CSA agreements for both OTC and centrally cleared swaps now specify OIS as the standard funding rate. Using dual curve stripping to create accurate swap valuation curves provides rates traders with superior decision support by ensuring that swaps are priced correctly. This helps to avoid both missed trading opportunities and the potential to initiate swap contracts at sub-optimal prices. Accurate pricing is also essential when evaluating multiple dealer quotes and for quickly spotting opportunities in less liquid segments of the swap curve.