COLLATERALIZED CURVE CONSTRUCTION
We have shown in Section 2.3 how curve construction evolves with market trends. The latest step in this evolution is the inclusion of collateral posting in the curve construction calculations. In this section we shall present some of the key steps in the evolution of the perception of counterparty credit risk and what this implies in terms of actual calculations. We shall also ask ourselves, does this really make a difference? To answer this question we shall stress how one needs to differentiate between the price of an instrument at inception and during its remaining life. Finally, we shall touch upon the special case of AAA institutions, which is the case of many development banks.
The Evolution of the Perception of Counterparty Credit Risk
When discussing FX forwards we mentioned how they tend to be common in less developed markets for reasons of simplicity and risk. We also mentioned that the immediate exchange of cash was the reason for their perceived (and in practice real) safety. What strikes the practitioner arriving to fixed income by way of another asset class, such as equity or FX, is the fact that everything is seen over a long period, contracts tend to have long maturities and a concept like accrual, foreign in other asset classes, is king.[1] Fixed income is about promises of repayments, repayments that only materialize after a certain period of time. This is bound to bring forward issues of credit.
A swap (we can keep this discussion general and imagine a trade such as the one shown in Equation 2.4, ignoring more specific types) is an exchange of payments between two parties. We said that at inception a swap is worth par, which means that neither side owes the other anything. As soon as the market moves the following day, particularly easy to see in Equation 2.4 since one side pays a fixed amount, this is no longer true. The swap will no longer have a zero value; it will have a positive value for one party and a negative value for the other: this is called the mark-to-market (MTM) of the swap. The MTM shows what the party that sees it as positive is owed by the other party. That amount is not owed immediately since the actual payment will take place only at some precise moment in the future (when the MTM will most likely have a different value), but the MTM is seen as the value of the trade should the trade be exited at that moment. To exit a trade, or unwind, is a voluntary operation agreed by both parties in which, after a set of transactions, the party owed the MTM is satisfied. Of course we can easily see where this argument is leading to, what happens in a non-voluntary situation, for example a default? The party that sees the MTM as positive is essentially exposed to the other party's credit risk. The solution to this problem has been the introduction in swap agreements (see ISDA 1994 [52] and ISDA 1999 [53]) of the standardization of collateral payment.[2] Every day the MTM of the swap is calculated and that amount is posted as collateral by the party that sees it as negative. The day after the MTM changes value, the amount of collateral will increase or decrease accordingly. Of course the MTM can change sign, which would turn the table on the party, which up to this point, was receiving the collateral. To avoid a continuous switching of sides over many trades, which would be operationally intensive, collateral is managed at a very high level, netting all positions between two counterparties and posting collateral only on that global MTM.[3] Collateral takes the form of cash or treasury notes, that is, the most liquid financial objects available.[4] We shall now look at what happens to the collateral posted.
- [1] I remember once a colleague saying, after taming a particularly tricky stream of accruals, “fixed income is all about dates.”
- [2] Mechanisms for collateral payments have existed at least since the late 1980s; however, the inclusion in ISDA agreements only took place in the 1990s.
- [3] One has to be careful, however, that netting is far from a trivial exercise and that it is carried out within a clear legal framework.
- [4] Sometimes securities are also posted but subject to a haircut, or discount, for fear that, in case of the default of the counterparty posting the collateral, they could depreciate faster than the receiver of the collateral is able to sell.
