Impact of OIS switch of fair value derivatives
Barely a day goes by, it seems, without an email, a post, or a newsflash from one of the many acronyms (ECB, BOE, FED, FCA, ISDA…) of the LIBOR reform players. We are getting closer to the deadline and there is still the same uncertainty on what the post-LIBOR market will be like. What will the transition look like? Will my margin calls be impacted? Will the fixed rate currently paid be changed? Will interest payment in arrears really become the norm for the loans and facilities too?
This article will not discuss the fallback or the race to have a SOFR credit add-on. That is not because this is not interesting or relevant, but rather because of the uncertainty around them. Instead, we focus on the change in the discounting curve for EUR derivatives and its implication for the market value (margin call) and fixed rate payer.
Focus on the discounting switch
One change that looks unremarkable and has not had much publicity is the discounting switch from one overnight rate to another. But touching the valuation assumptions of derivatives triggers changes in market value, and therefore creates a number of questions. How will the market value of the derivatives change after the switch? What is the impact in case the deals unwind? Can it have an impact on my collateral/margin call?
In the examples below, we present the change from an EONIA curve to an ESTR (a new reference risk free rate for EUR) curve for a EUR derivatives portfolio. With EONIA to cease existing as of 1 January 2022, more banks will be willing to switch to the ESTR discounting curve in the coming months. Although the ESTR rate has been set as EONIA minus 8.5 basis point (bp), it does not mean that all curve tenors (all maturities) are carrying the same spread. Figure 1 presents the EONIA and ESTR swap curve as of 26 February 2021. It can be seen that the difference on the long-end part of the curve is navigating around 8.5 bp, but not exactly.
Figure 1: Difference between EONIA and ESTR curves
Impact on market value
Next, we will provide an estimated impact of the discounting change in term of market value and fixed rate. We have made an assessment with fixed rate payer swaps with semi-annual payment frequency against 6-month Euribor with a notional of 10 million and 4 different maturities. The results in basis point on notional are presented below. The basis point is calculated as:
Figure 2: MtM differences for several tenors and par rates
The graph above shows that the impact is higher when the maturity is higher and when the deal is more out of the money (higher liability). In this example there is a calculated impact up to 29bp.
The BP impact is not depending on the notional. Therefore, it is very simple (for similar swap characteristics) to calculate the EUR impact on another notional and consequently the ESTR market value.
Table 1: Market value for EONIA and ESTR
Although in the example, the EUR impact can be seen as limited for one deal, it can quickly be material when the portfolio is bigger (deals or notional).
Impact on fixed rate
It is interesting to understand the impact not only on the market value but on the fixed rate payer too. The discounting curve is changing the market value of the instrument, which brings up the question as to how much the fixed rate should change to have the same market value. The impact can be up to 1.9 basis point less on the coupon. That would mean that in place of having a fixed rate of 3.265% (with EONIA discounting curve, scenario of a rate at par+3% and a maturity of 15 years), the fixed rate should be decreased to 3.246% (with ESTR discounting curve) to have the same market value, for example. We believe that it is important to assess the impact of the discounting change on your portfolio and be pro-active with your counterparties to determine what the possibilities are regarding compensation or fixed rate adjustments.
Figure 3: Fixed rate differences for several tenors and par rates
Here to help
Switching to ESTR should be done with care, as the value of the derivatives/portfolio can change drastically. The impact can be in the thousands, if not millions of euros dependent on the portfolio size. Zanders can help you with estimating the impact on your portfolio, or support you in the discussions with your counterparties.