In this video blog CMO, Jim Jockle speaks with Dr. Alexander Antonov, Senior VP of Quantitative Research, co-author of the recent Risk Collateral Management Cutting Edge feature “Options for Collateral Options.”
Current credit support annexes (CSAs) are complex, specifying rules for posting collateral in different currencies. When multiple currencies are allowed, this choice leads to optionality that needs to be accounted for when valuing even the most basic of derivatives. Leveraging a deterministic approach, interest rates in different currencies can be projected at certain points in the future, where the cheapest option at each point in time is used to discount the derivative.
However, the question on everyone’s mind is what about optionality and how can it be modelled? By leveraging smart approximations with certain assumptions Dr. Antonov and Barclay’s Dr. Vladimir Piterbarg propose a new approach to modelling the optionality of collateral currency choices continuously throughout time, potentially leading to more sophisticated interest rates that could be applied for discounting versus simply selecting the future cheapest rate.
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Video Transcript: A Quantitative Approach to Modelling Optionality within Collaterals
Jim Jockle (host): Hi, welcome to the Numerix video Blog, I’m your host Jim Jockle. Continuing on the theme that we see in the market of vanilla instruments getting more and more complex especially around derivatives pricing and all of the inputs not as it relates to profitability, join us today is Alexandre Antonov, SVP of Quantitative Research at Numerix – Alexandre how are you?
Alexandre Antonov (guest): I’m fine thank you Jim.
Jockle: Thank you for joining us. The think I want to talk to you about – if you haven’t seen it already in Risk Magazine in the March edition it is a must read, a co-authored paper by Alexandre Antonov and Barclay’s Vladimir Piterbarg titled “Options for Collateral Options.” I just want to give a very quick summary from the report – then get into a couple questions.
So the summary is: When collateral can be posted in multiple currencies, pricing even the simplest derivatives involves optionality, which is often tackled numerically. But by conditioning on a risk factor to make variables independent, this can be simplified. This paper shows that this approach is both quicker and more accurate than more obvious methods.