P2.T5.408. Hull on overnight indexed swaps (OIS) and collateral rate adjustment

Nicole Seaman

Director of CFA & FRM Operations
Staff member
Subscriber
AIMs: Explain criticisms of the use of LIBOR as a risk free rate for valuing non-collateralized portfolios. Describe the Collateral Rate Adjustment (CRA) in a collateralized portfolio and explain how the CRA is calculated when cash and non-cash collateral are present. Compare the use of the OIS rate and LIBOR as a risk free rate in valuing collateralized portfolios.

Questions:

408.1. If f(nd) is the no-default value of a portfolio, which best expresses the value of the portfolio after credit risk adjustments where neither counterparty posts collateral:

a. f(nd) plus (+) CVA plus (+) DVA
b. f(nd) minus (-) CVA plus (+) DVA
c. f(nd) minus (-) CVA minus (-) DVA
d. f(nd) minus (-) LIBOR(t) plus (+) OIS

408.2. The thrust of Hull's argument (in the assigned reading) is that the overnight indexed swap (OIS) rate is the appropriate discount rate to be used in order to determine the no-default value of a derivate (or derivatives portfolio). However, does Hull provide for any exceptions?

a. No, Hull says the discount rate should always be OIS
b. Yes, the rate should be LIBOR if a LIBOR interest rate reflects the bank's actual borrowing costs
c. Yes, the current practice of using the rate paid on collateral as the discount rate is a good approximation of the discount rate conditional on a zero-threshold, two-way collateral agreement
d. Yes, the current practice of using the rate paid on collateral as the discount rate is a good approximation of the discount rate conditional on the requirement that collateral is transferred continuously

408.3. According to Hull, under which of the following condition(s) can we adjust for credit risk (i.e., default risk) by adjusting the discount rate?

a. When the derivatives portfolio is always an asset (i.e., always has a positive value) to the dealer
b. When the derivatives portfolio is always a liability (i.e., always has a negative value) to the dealer
c. When the borrowing rates are identical for the dealer and the counterparty (i.e., if the counterparty and dealer have identical credit spreads)
d. Under any of above (all three) conditions

Answers here:
 
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