When it comes to investing in financial instruments, valuation is not just critical to determining a vehicle's fair market value, but it is also essential for financial repor♍ting and risk analysis functions.

The most common valuation tool, known as the discounted cash flow (DCF) method, is used to project future cash flows, while simultaneously highlighting the likely 澳洲幸运5官方开奖结果体彩网:discount rates attached to those cash flows. One way to arrive at the correc💧t discount rate is to look to ♕the overnight swaps market (OIS).

Derivative Valuations Be𓆏fore and After the 2008 Economic Crisis

Financial 澳洲幸运5官方开奖结果体彩网:derivatives introduce diversification to an investment portfolio by facilitating exposure to different markets. The value of these derivatives assumes that the returns on all underlying assets are based on the 澳洲幸运5官方开奖结果体彩网:risk-free rate. Therefore, the real rate at which those underlying assets grow does not materially affect their values🅺. This concept is known as “risk-neut🎀ral” valuation.

Before the 2008 financial crisis, 澳洲幸运5官方开奖结果体彩网:government bonds were deemed risk-free investments. After all, it is nearly impossible for the government to default on its debt when the U.S. Treasury can simply print more money to satisfy debt obligations. Furthermore, swap rates based on interbank lending rates (LIBOR, Euribor, etc.𓆏) were broadly considered to be risk-free. Swap rates were consequently deemed more appropriate for risk-neutral valuation than bond yields because proceeds from derivative transactions are generally invested in the interbank market, as opposed to the bond market.

Following the 2008 financial crisis, the failure of some banks signaled that interbank lending rates were not indeed risk-free, as🅠 previously thought. Many derivative investments demonstrated significant counterparty risk because transactions were not subject to collateral or margin ca🐽lls.

Such counterparty risk famously led to the bankruptcy of investment banking giant 澳洲幸运5官方开奖结果体彩网:Lehman Brothers. As the counterparty to over 900,000 derivative transactions, representing approximately 5% of global derivative activity, the bank was unable to crawl out from under its crushing $613 billion debt, and ultimately shuttered its doors for good.

Collateralized Versus Uncollate🍨ralized Derivatives

Derivatives that trade over-the-counter (OTC) employ standard 澳洲幸运5官方开奖结果体彩网:ISDA agreements that frequently include 澳洲幸运5官方开奖结果体彩网:Credit Support Annex (CSAs), which are clauses that outline permissible credit mitigants for a transaction, such as netting and collateralization. Collateralized transactions pose less counterparty risk because the collateral can be us🍰ed to🌠 recoup any losses. When such collateral falls below a certain threshold, more can be sourced.

Differences in risk profiles between col🦩lateralized and uncollateralized deals invariably lead to divergent valuation discount rates. As the less risky of the two, collateralized derivatives must be valued with risk-free rates.

OIS Discountiꦇng and Risk-Free Rates for Collateralized Derivative🐓s

Standard CSA agreements limit losses by mandating daily collateral calls in order to prevent counterparties from closing out. Amid this backdrop, the natural choice for the risk-free discount rate is typically some type of 澳洲幸运5官方开奖结果体彩网:overnight rate. This is r🧔eferred to as "OIS discounting" or "CSA discounting." Overnight yield curves can be derived from overnight index swaps (OIS).

Prior to the financial crisis, there was little difference between the overnight yield curve and the yield curve derived from swap rates. During the crisis, the spreads between the two yield curves widened substantially. Although overnight index swaps were introduced relatively recently, developed nations like Japan and Switzerland boast highly liquid OIS, enabling more reliable valuations.

Although countries lacking sufficiently liquid OIS markets may struggle to determine valuations, they may lean on workaround solutions that entail creating synthetic cross-currency OIS that utilizes a liquid OIS curve as the base, and applies a cross-currency basis spread to derive a local currency OIS curve. If options are collateralized and the option margin earns an overnight rate, OIS discounting ca🅰n be applied. As a rule, call options yield lower values, while put options exhibit higher values.

The Bottom Line

To determine the market value for an investment, a valuation is traditionally pe🌸rformed using the discounted cash flow (DCF) method. For the value to be fair, the discount rate must be the same as the rate of return.

Although derivatives were historically considered to be free of counterparty risk, this notion changed following the 2008 financial crisis. In the current economic climate, collateralized derivative trades re🅠duce counterparty risk and must consequently be valued using a risk-free rate.