Over-the-counter Derivatives: Need a better pricing model
Over-the-counter interest rate derivatives played a crucial force in the downfall of Wall Street in 2008 financial crisis. With a recently-healed global economy, there is a strong demand for mathematicians to improve current evaluation methods for this type of risky asset by taking into account in their models the future monetary policy of central banks.
What are derivatives?
As an informal explanation, derivative securities are the value of that which depends on other securities. As Investopedia provides in their comprehensive definition: “The derivative itself is a contract between two or more parties based upon the asset or assets. Its value is determined by fluctuations in the underlying asset. The most common underlying assets include stocks, bonds, commodities, currencies, interest rates and market indexes.” You will see some of the most popular derivative productions are currently being traded on the financial market: future contracts, forwards, swaps, options, credit derivatives and mortgage-backed securities.
There are only futures contracts and options that are being traded on heavily regulated exchanges with rigorous rules that clearing corporations imposed on their buyers/sellers. Typically these exchange traded products have moderate risk for investors to hold due to the heavy supervision by government agencies.
However, the rest of derivative products (swaps, forwards, credit derivatives and mortgage-backed security) are usually over-the-counter (OTC), in which buyer and seller negotiate the price amongst themselves. To explain the popularity of OTC derivatives is simple; many companies and investors find it easier to negotiate both price and maturity of the contracts, which can create favourable numbers in their accounting system. Regardless of its flexibility, this also brings a higher risk for investors to hold as buyer and seller did not go through a rigorous financial background check.
Currently, the global derivatives market has a notation outstanding value of 1.4 trillion dollars and according to BIS (Bank of International Settlement) the derivatives being traded OTC (Over-the-Counter) were valued at 553 trillion in 2015. According to the most recent report from ISDA (International Swap and Derivatives Association), the notational outstanding values of solely interest rate derivatives is 435 trillion.
Derivatives have a long due history started from ancient Greece, continuing to feudal Japan and onto its first appearance at the CBOT (Chicago Board of Trade) in 1960. Derivatives have been commonly used first and foremost in the form of forward contracts to help famers/buyers make profits from their commodities without being effected by the uncertainty of the future. After a few centuries, derivatives still majorly provide a solution for fund managers to hedge their risk from other projects, which later lead to the overuse of interest rate derivatives in the 2000–2008 period
Read more about the history of derivatives.
A double-edge knife
Derivatives, especially interest rate derivatives and swap commonly use a hedge instrument for investors. Credit default swap (CDS) allows businesses to hedge their business risk. A swap simply allows buyers and sellers to exchange their cash flow in a finite amount of time. A CDS behaves like an insurance policy which allows the buyer of this cash flow to recover their loss from future failure.
However, OTC derivatives has been criticized as one of the key factor lead to the financial crisis in 2008. In particular, during the frantic period, financial institution even write their over-the-counter CDS contracts with low-quality subprime mortgage-backed securities (MBS). The overuse of over-the-counter CDS contract which lead to the enormous risk exposure in the financial industry, banks and financial institution are liable to provide the cash flow back when the business defaulted. Combining with the simultaneous collapsed of Collateralized Debt Obligation (CDO) and Mortgage-backed Securities (MBS) in housing sector, the appearance of Credit Default Swap further amplifies the housing crisis and eventually paralyzed entire financial sector as a whole in 2008.
Lack of regulations and poor understanding of the complicated nature of derivatives has prevented even the most sophisticated investors to control and to be aware of the financial consequence. Central bank even after the 2008 financial crisis are still picking their hairs out to find the most effective way in order to monitor the type of instruments.
Pricing model and monetary policy
Pricing model of derivatives generally are difficult to estimate before Black Scholes formula was introduced. But as time and technology evolved, we see the accelerated in learning curves which resulted in variety of state-of-art pricing models. Currently to evaluate the term structure of interest rate derivative or swap there are 2 ways: spot rate and forward rate approach.
With spot rate approach, mathematician usually using Vasicek Model to estimate the future of interest rate. On the other hand, forward rate approach usually using Heath–Jarrow–Morton framework to evaluate the term structure of interest rate.
Read more about evaluate the term structure of interest rate.
This two common approaches showed in many studies that it’s make exogenous assumption and lack of flexibility in term of cooperating its external environment (in this case monetary policy) into the estimation. Monetary policy plays a significant role in determining the price of interest rate derivatives and swaps as these instruments have underlying assets are sensitive to change in interest rate. Moreover, monetary policy is a main tool for central bank to control the economy and help the transition of recession to expansion or vice versa smoothly. Government usually adjusts interest rate with other economics indicator.
It is interesting that even with pricing model for normal options and swaps, there are no room to incorporate expected monetary policy in the price predictions. This overlook resulted in mispricing the derivatives and lead to ineffective risk management of derivatives. A pricing model with high accuracy will not only crucial for the risk management purpose but also helping entire derivative industry maintain the stability of financial market in general.
Conclusion
We learn a big lesson from the financial crisis 2008 in term of regulated Collateralized Debt Obligation and Mortgage-backed Securities, but it is urgent to come up with a better pricing model for interest rate derivatives to help management its risk as well as coming up with strong regulation in OTC industry. As the global economy is reaching its peak, central banks and the financial industry need to be alert about the risk and not make the same mistake twice.
