Derivative pricing practices have evolved in recent years to reflect the funding benefit of collateral when that collateral can be rehypothecated. In fact, some collateralized derivatives may now need to be valued based on discounting at the Overnight Indexed Swap (“OIS”) rate.
Derivative pricing practices have evolved in recent years as market participants refine their pricing approaches to capture the elements underlying the pricing of derivative transactions in a changing market.
One area that has continued to evolve relates to pricing assumptions on collateralized derivatives. For many years market participants utilized collateral on bilateral over-the-counter (“OTC”) derivative transactions as a means of mitigating the credit risk of their counterparties. Following the lessons learned during the financial crisis, many market participants recognized that the funding advantages from collateral that may be rehypothecated has value that should be considered in derivative pricing.
The incorporation of these funding advantages has had a broad impact on derivative pricing as a result of the increasingly common use of collateral on derivative transactions. The increased use of collateral has been driven by an increased focus in the OTC market on credit risk and funding risk management, as well as by the migration of derivative activity to clearing houses where transactions are typically fully collateralized. As a result, certain collateralized derivatives may be presumed to require valuation based on discounting at the Overnight Indexed Swap (“OIS”) rate.
The derivative pricing changes also impact uncollateralized transactions as market conventions for the way prices are quoted for reference instruments, such as interest rate swaps, have changed.