Prof. Jayanth R. Varma's Financial Markets Blog

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Prof. Jayanth R. Varma's Financial Markets Blog, A Blog on Financial Markets and Their Regulation

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Fri, 15 Jul 2011

Indian uncollateralised derivative markets

An article by Christopher Whittall in the International Financing Review (IFR) about the difficulties in valuing uncollateralised derivatives is of great relevance to Indian OTC swap markets. Christopher Whittall explains in his article that “Unsecured trades now present a serious valuation headache”. FT Alphaville follows up on this story and highlights the problem: “... pricing even the most basic (uncollateralised) swaps is now very complex. ... traders just flat refuse to enter into any detail about how they price uncollateralised derivatives nowadays — hardly a positive thing for a market that is regularly accused of being like a black box. ”.

Over the last few years, the two curve discounting model which discounts cash flows using the OIS curve (see my blog post of last year) has emerged as the market standard for valuing collateralised swaps. This technique is not applicable for uncollateralised swaps, and in fact there is no “market” valuation for these swaps because the value depends on the cost of funds of the two parties via the Credit Value Adjustment (CVA) and Debt Value Adjustment (DVA).

Deus ex Machiatto puts the matter succinctly:

A vanilla derivative is a collateralized one under the standard CSA these days (cash collateral in the same currency, daily MTM, daily margin). Anything else is exotic, because it involves an exotic collateral option.

All this is important for Indian OTC swap markets because the market runs largely without collateralisation. While these swap deals are governed by the standard ISDA (International Swaps and Derivatives Association) documentation, most Indian banks do not sign the Credit Support Annex (CSA) that deals with collateralisation. We have tended not to worry too much about the Indian OTC swap market because it is dominated by plain vanilla interest rate swaps. What Whittal and Deus ex Machiatto are saying is that this view is incorrect. Effectively, these are all exotic derivatives because of the lack of collateralisation. I believe that this is correct and the matter needs urgent regulatory attention.

There are three main ways to set things right:

I believe that it is necessary to move quickly along one or more of these alternative paths to mitigate the risks in this market.

Posted at 13:31 on Fri, 15 Jul 2011     2 comments     permanent link


Mudit Gupta wrote on Sat, 16 Jul 2011 13:38

Re: Indian uncollateralised derivative markets

Hello sir, though on a unrelated note: Can u suggest a topic for my dissertion MBA nirma university-(project time period -4 to 5 months) Majors-Finance And also the blogs you follow and articles i should read. I have read your article on finance curriculum and research what should be incorporated. If you can help me with the notes you can share about those topics. Anticipating your positive response. Warm regards.

Kushankur Dey, IRMA wrote on Sun, 17 Jul 2011 21:48

Re: Indian uncollateralised derivative markets

Presumably, CBLO is a proven step taken by debt-segment of capital markets with a varied degree of collateral and lending period. In derivative segment, India is on the verge of introducing the same but with different nomenclature. Being a prudent measure against the credit risk and subsequently, idiosyncratic risk of organisation, collateralised products would promise to perform a better risk measure.