The impact of collateralization on swap curves and their users

Master Thesis Investment Analysis

Mohammed Saadullah Ansari

The impact of collateralization on swap curves and their users

Master Thesis Investment Analysis

s977172

University supervisor:

Prof. Dr. F.C.J.M. de Jong

Finance department

School of economics and business

2
Abstract
Derivative contracts are increasingly being collateralized in order to mitigate counterparty credit risk.
The fact that collateralization makes the contract (close to) riskless has consequences for the discount
rate used. This discount rate should not be based on the swap curve, but on the growth rate of the
collateral specified in the Credit Support Annex (CSA). If the collateral is cash based, which it usually is,
the overnight index rate (OIS) is closest to matching the single day credit risk of collateralized derivatives
and should therefore be used as the discount rate. The result is a different valuation which can have big
impact if the spread between the swap curve and the overnight curve increases. After years of a stable
near-zero spread, the Euribor-OIS basis exploded in 2007, resulting in a market-wide shift to OIS
discounting of collateralized derivatives. The effects of this reach beyond the derivative markets,
because collateralized interest rate swaps are the basis for building zero curves used to discount all
future cash flows. With the swaps being the instruments to build zero curves, the changes affect the
valuation of all cash flows to be discounted.

The theoretical evidence leaving no doubt, an attempt is made to empirically determine the impact on
different hedging strategies in the stress scenario that has occurred during the credit crunch. This stress
test leads us to conclude that there is a significant difference in hedge effectiveness when switching to
OIS discounting, confirming the theoretical need for proper accounting. It is determined that more
sophisticated two-curve hedging methods are promising but require more testing and support in the
form of liquid OIS markets. It can be concluded that there is little doubt that collateralized derivatives
should be discounted based on the underlying CSA and that, when setting up a hedge or building a zero
curve, multiple curves have to be accounted for.

3
Contents
ABSTRACT 3

CONTENTS 4

1. INTRODUCTION 6

2. THE PRICING OF INTEREST RATE SWAPS 10

2.1. Uncollateralized IRS 10

2.2. Overnight index swap 12

2.3. Cash Collateralized IRS 14

2.4. Bond collateral 17

2.4.1. CSA optionality 20

3. CURVE CONSTRUCTION 21

3.1. Curve instruments 21

3.2. Curve building 21

3.2.1. Curve interpolation 22
3.2.2. Curve use 23

3.3. Forward adjustment 24

4. INTEREST RATE SENSITIVITY 25

4.1. Single curve interest rate sensitivity 25

4.1.1. Intermezzo: Cash instrument 27
4.1.2. Swap instruments cont’d 28
4.1.3. Interpolation 31

4.2. Double curve interest rate sensitivity 33

4.2.1. Validation 38
4.2.2. Intermezzo: Correlation 41
4.2.3. Double curve sensitivities cont’d 42

4
5. APPLICATION IN A PENSION FUND 44

5.1. Pension fund characteristics 44

5.2. Testing methodology 48

5.2.1. Hedge ratio 49
5.2.2. Setting up a hedge: Dividing delta in buckets 50
5.2.3. Single hedge vs bucket hedge 52
5.2.4. Eonia liquidity 53
5.2.5. Cash account & equity 54
5.2.6. Sample period events 55

6. RESULTS 57

6.1. Not hedging 58

6.2. Hedging to Euribor only 59

6.2.1. Hedging with Euribor discounted swaps 60
6.2.2. Hedging with OIS discounted swaps 62

6.3. Using two curves to determine the hedge 64

6.3.1. Double curve hedging 66

6.4. Upswing scenario 68

6.4.1. Upswing scenario analysis 68

7. CONCLUSION 70

7.1. What is the impact of collateralization on swap curves and their users? 70

7.2. Limitations & extensions 71

7.3. Recognitions 72

8. REFERENCES 73

9. APPENDIX 75

5
1. Introduction
The traditional approach to interest rate swap (IRS) valuation treats a swap as a portfolio of forward
contracts on the underlying floating interest rate. Under specific assumptions regarding the nature of
default and the credit risk of the counterparties, Duffie and Singleton (1997) prove that swap rates are
par bond rates of an issuer who remains at LIBOR quality (AA credit rating, Hull, 2010a) throughout the
life of the contract. Due to increasing popularity, more diverse counterparties entered the market which
led to measures to mitigate credit risk on swap contracts. (Johannes et al. 2007)

In the case of a swap, what matters to a counterparty in the event of a default is the market value and
the replacement cost of the swap: what it costs to put on a new swap with equal characteristics. Even
though market risk is covered by the swap, counterparty credit risk arises as a result of the contract. A
way to lower counterparty risk is collateralization combined with (daily) Marking to Market (MtM).

ISDA (2001) finds that “more than 65% of plain vanilla derivatives, especially interest rate swaps” are
collateralized according to the CSA (Credit Support Annex, a standardized legal agreement on collateral).
Most collateral is posted in the form of either cash or government bonds. Other, riskier assets are
possible but these are likely subject to a bigger haircut than the small one on government bonds (ISDA,
2003). ISDA (2001) also finds through a survey that 74% of market participants MtM at least daily. A
collateralized interest rate swap that is marked to market daily has (almost) no credit risk. He (2000)
states about this: ‘The current industry practice has essentially removed (in a significant way if not
completely) the risk of default by either counterparty so that, for all practical purposes, swaps shall be
valued without the consideration of counterparty risk.’ ISDA(2011) finds that in 2010, 70% of all OTC
derivatives transactions were subject to a collateral agreement, of which 81% was collateralized with
cash, and most of the remainder with government securities. It is possible that only one of the parties in
an OTC contract is obligated to post collateral, especially when there is a big difference in credit rating.
However, ISDA (2003) concludes that bilateral collateral agreements are market practice on swaps,
meaning that both parties post collateral if their position has a negative market value.

Before the credit crunch, the default-risky Libor curve was used to discount the future cash flows of a
swap contract, even though most contracts were already collateralized at the time. (Johannes et al.
2007) This was not a problem because the risky Euribor curve and the risk free curve were almost equal
so that the valuation differences from using another curve for discounting were negligible. However, the
spread between the risk free Eonia1 overnight rate and the swap rate has increased since then, coming
from nearly zero. As a result, collateralized swaps are increasingly discounted using the Eonia index
while uncollateralized swaps are still discounted using the swap curve. (Koers, 2010) Also Fujii et al.
(2009b) conclude that ‘Libor discounting is inappropriate for the proper pricing and hedging of
collateralized contracts.’

1
Euro Over Night Index Average

6
The 6 month Eonia-Euribor spread is depicted in graph 1 below, to illustrate the magnitude of the
spread increase after years of near perfect correlation and a near-zero spread.

Graph 1: 6month EONIA versus 6month EURIBOR

6.00%
Spread Bankruptcy Lehman
5.00% Start Crisis
Euribor
4.00%
EONIA
3.00%

2.00%

1.00%

0.00%
Mar Mar Mar Mar Mar Mar Mar Mar Mar Mar
2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
The spread starts to widen at the beginning of the crisis, and reaches its peak at just over 200 basis
points around the Lehman Brothers bankruptcy event. After that, the curves converges to a reasonably
stable spread of about 40 basis points. This pattern is also observed outside the euro area; in the US, the
3 month Libor – OIS2 basis reached a peak of 366 basis points in October 2008 (Whittal, 2010a), after
which the curves converged to a lower spread.

Another indicator of credit risk, or as Paul Krugman (2008) calls it, an indicator of lack of trust in the
economy, is the TED spread. This is the spread between 3 month US Libor and the interest rate on 3
month treasury bills.

Graph 2: 3m US Libor versus 3m T-Bill: The TED spread

6.00%
TED-spread
5.00% US Libor
US T-Bill
4.00%

3.00%

2.00%

1.00%

0.00%
Mar Mar Mar Mar Mar Mar Mar Mar Mar Mar
2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

2
Overnight index swap, the overnight rate which is Eonia in the Euro area. In the US this is the Federal funds rate.

7
The TED spread has different absolute values but follows the same pattern as the Euribor-Eonia spread,
with the same two peaks indicated in graph 1. This illustrates the global reach of the liquidity crisis
around those two events and makes clear that a spread that has been constant for years can suddenly
explode.

Given that collateralization leads to risk-free discounting, the impact of credit spreads can be very large.
The shift is supported by Fujii et al. (2009b) who show that when a contract is collateralized, the
collateral rate should be used for discounting. For cash collateral, this is the Overnight Indexed Swap
rate (OIS) which is Eonia in the euro zone, the federal funds rate being its counterpart in the US. Also,
one of the biggest clearinghouses in the world, LCH.Clearnet, recently shifted to OIS discounting, after
consulting its members and concluding that ‘the market has come to the consensus that this is the
correct way to value swap trades.’(Whittal, 2010b)

Accounting rules nowadays are aimed at transparency through fair value accounting, for which IAS39
states for over the counter derivatives: ‘the valuation technique is consistent with accepted economic
methodologies for pricing financial instruments and incorporates all factors that market participants
would consider in setting a price.’ Given the market consensus described above, OIS discounting should
be accounted for by all OTC derivative users. Besides the transparency argument, proper discounting
should also reduce to likelihood of closing collateralized derivative positions with positive mark-to-
market value against too low of a price. If one party in the transaction uses a non-risk-free curve, the
other party could benefit by using its knowledge advantage. This should not be possible in the
sophisticated financial world today.

The consequences of the shift to risk free discounting in combination with a spread increase are not
limited to the swap market. All derivatives and future cash flows are discounted with a discount curve
which is primarily built from swaps subject to a change in valuation. This means that the swap curves
change which has an impact on the zero curve used for discounting, thus affecting the value of all
financial objects that are discounted.

On the contract level, collateral other than cash can be used, which would make the discount rate
different. An appropriate rate when bonds are used as collateral is the repo rate for that bond.
However, this imposes some problems, as repo rates are not as widely and publicly available, ‘always
leaving room for discussion on the exact amount’ (Verheijen, 2009). This is contrary to OIS rates, which
are published daily. The haircut imposed on the repo transaction varies and this has an effect on the
repo rate, making the effective rate hard to observe.

Regardless of the collateral used, a collateralized swap has exposure to more than just the underlying
swap curve. Since the discounting is done with a risk-free curve with or without a repo spread, there is
also exposure to the discount curve. Besides this, the exposure to the Euribor curve changes as it is no
longer used for discounting. This is discussed in section 4.

The above can have major impact on financial institutions with large interest rate exposure, such as
pension funds and insurance companies. The liabilities of defined benefit (DB) pension funds have to be
discounted with a market interest rate according to IFRS. Due to the long duration of the liabilities, the

8
funding ratio of a pension fund is very sensitive to the interest rate used for discounting. The funding
ratio is defined as:

Here, in the case of a DB scheme, the liabilities are the built up pension rights. In the Netherlands, which
has a large pension sector, the discount curve is the euro swap curve under the FTK regulation for
pension funds. The regulator also prescribes a minimum funding ratio of 105%. As a result, all Dutch
pension funds that hedge their interest rate risk, do so with respect to the euro swap curve to protect
their funding ratio from falling below 105%. In this process, the euro swap curve is not only used to
determine the swap quotes, but also used for discounting of the contract. As the valuation section will
show, this is perfectly fine for uncollateralized swaps. But given the fact that the great majority of the
swap contracts is collateralized, this is no longer appropriate. The same can be said about the interest
rate sensitivity and resulting hedge strategy of the fund. New hedging policies might be required.
In particular, sections 6 and 7 will focus on a stylized Dutch pension fund, which will be used in an
attempt to quantify the hedge effectiveness of different hedging strategies in a crisis scenario. The
testing environment will be the situation where the hedge is most needed: a crisis scenario where
Euribor and Eonia go down and diverge in a short time span. The recent credit crisis in which the interest
rates moved as depicted in graph 1 will be used as the stress scenario.

The goal of this thesis is to analyze the impact of collateralization on swap curves and their users. The
first part will cover the effects of collateralization on the valuation and interest rate sensitivity of
interest rate swaps. When the technicalities are treated, the different hedging strategies will be
researched to reach a conclusion about the optimal hedging policy for pension funds and other financial
institutions, given the new financial order after the crisis.

In the next section, the pricing of swaps with and without collateral is discussed, after which the
construction of curves will be elaborated on in section 3. Section 4 investigates the interest rate
sensitivity for both collateralized and uncollateralized swaps to one or more curves. The technicalities
end in section 5 where the testing methodology is described. Section 6 presents the results from the
tests described in section 5. Finally, section 7 concludes.

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2. The pricing of interest rate swaps
In this section, the valuation of interest rate swaps (IRS) is discussed for contracts with and without
collateral and different underlying curves.

2.1. Uncollateralized IRS

The traditional approach to interest rate swap valuation treats a swap as a portfolio of forward contracts
on the underlying floating interest rate. It is then valued by separately assessing both the legs of the
swap. The fixed leg is equal to a fixed rate bond without the notional being exchanged. The floating leg
is equal to a floating rate bond without exchanged notional. At initiation, the value of both the legs is
equal, making an interest rate swap a product which does not require an initial investment. The fixed
rate which makes the value of the contract zero; the par swap rate; is quoted in the market.

Both legs are valued by discounting all the future cash flows. Since the future payments of the floating
leg are unknown, forward rates are used for valuation. If this would not be accurate, arbitrage
opportunities would occur.

For the sake of illustration, we value a simple 1-year swap with a notional of 1, with the floating leg
paying the 6 month Euribor rate every 6 months and the fixed leg paying the agreed fixed rate annually.
This is the common market practice in the Euro zone.3 First, some definitions:

4
(1)

5
(2)

When a symbol of the above is used to indicate an overnight index swap rate, and is thus related to
EONIA, the superscript OIS will be added.

3
For USD and GBP swaps, the leg tenors are different.
4
Simple compounding is used here, since the underlying Euribor curve is simple compounded. Ametrano and
Bianchetti (2009) also use simple compounding in their work.
5
Derivation on the next page.

10
We will now value a one year swap, which has two legs, each with a stream of cash flows that have to be
discounted. The fixed leg pays annually and thus pays one fixed cash flow, which is valued as:

To value the floating leg, we first need to define the forward rates as function of discount factors.
In the simple compounded world, there would be arbitrage opportunities if the following relation would
not hold for the two year case:

The one to two year forward rate is then easily found as:

Then, we reverse (1) to express discount factors as a function of zero rates:

We can use this result to rewrite the one to two year forward rate:

This result is generalized in (2), and is required for valuing the floating leg of the one year interest rate
swap. The floating leg is valued by discounting all cash flows; the payment in 6 months and the final
payment in one year:

11
This result also holds for multi-year swaps; which makes it an easy pricing method.

The results can be generalized to the following6. Note that the alphas are differentiated here, because
the floating leg has semi-annual periods while the fixed leg has annual periods.7

(3)

(4)

(5)

The value of a receiver swap is then the fixed leg minus the floating leg, while a payer swap is the
opposite.

2.2. Overnight index swap

An overnight index swap (OIS) is a collateralized product which swaps a fixed rate for the overnight
interest rate. The fixed leg is valued similar to an uncollateralized single curve swap, but now the
underlying curve is the OIS curve. The floating leg is different, as it pays the daily rate instead of the six
month rate. The actual payment, however, only takes place yearly. This means that the reset dates are
not simultaneous with the payout dates, and thus interest is accrued over these reset payments.

Equation (4) can be rewritten with OIS discount factors and a fixed rate from the OIS curve, which leads
to:

(6)

6
The fixed and floating leg are valued separately and not summed to obtain the value of a swap. The ‘value of a
swap’ is trivial because it is not clear whether a payer or receiver swap is meant. If there is reference to the value
of a swap in this thesis, the value to the counterparty being discussed is meant.
7
From now on, every time it could be unclear what period is meant, the superscripts will be added.

12
The floating leg has, as stated, a different approach. The daily realizations of the floating OIS rate accrue
the Eonia interest rate, which leads to the following:

Note that the day count fractions concern business day periods here.8 By rewriting the forward rates
similar to (2) we get:

For a one-year OI swap, this results in:

This reduces to

Which can be generalized to:

(7)

This is equal to (6). We can thus conclude that the OI par swap valuation method is equal to that of an
uncollateralized Euribor swap, but that a different curve is used.

8
It looks here as if there are 365 resets in a year. This is not the case, resets only occur on business days. In the
weekends and on holidays, the compounding takes place using the daily rate of the last business day.

13
 2.3. Cash Collateralized IRS9
If the swap contract is subject to a CSA which specifies Euro cash to be used as collateral, there is
exchange of collateral when the market value of the contract changes. Assuming that the marked-to-
market value (MtM) of a bilateral swap is positive for the bank, the counterparty, in this case a pension
fund, has to post collateral. When the CSA specifies that collateral can only be posted in cash, and also
specifies a single currency (here: EUR), the cash flows look like the following:

Figure 1: Cash collateral process

EONIA
Pension
Bank Fund
Cash collateral

Cash EONIA
collateral

Money
Market

The pension fund has to post collateral to the bank and does so with EUR cash. The bank pays daily
Eonia10 as a fee over the collateral to the pension fund. This is common practice in the swap market
(Johannes and Sundaresan, 2007) The bank finances this by posting the collateral in a money market
account11 on which it receives EONIA. The collateral account is balanced daily and the reverse position is
also possible. In this case, the MtM of the swap is positive to the pension fund and thus negative to the
bank. The process is then reversed; the bank borrows money in the money market to post as collateral
to the pension fund, for which it receives EONIA. The latter is used to pay the fee to the money market
counterparty.

The amount of collateral posted equals the present value of the future cash flow. The interest rate of
the collateral thus determines how much collateral should be posted, making the growth rate of the
collateral the discount rate for the value of the derivative. (Lansink & Potters, 2011) This can be

9
See Fujii et al. (2009b) and Piterbarg (2010) for the proof.
10
For British pounds, SONIA would be the EONIA equivalent. In the US this would be the Federal funds rate.
11
The money market is exemplary to illustrate the revenue from the collateral for the bank. In practice, the bank
could loan out the collateral cash to another bank for one day, for which it would receive EONIA over the amount.
If the bank does not lend out the money because it needs it to finance other activities, it has less need to borrow.
As the bank would have to pay EONIA over this loan, it ‘saves’ the interest burden due to the collateral posting.
Regardless of what it does with the money, the bank earns EONIA over the amount posted by the pension fund.

14
illustrated by assuming a positive MtM for one party. Suppose the bank has a positive MtM and thus
receives, ceteris paribus, a cash flow at the next settlement date, which is the date the contract
matures. The collateral the pension fund has to post is the present value of this cash flow. This present
value is calculated by multiplying the future cash flow with a discount factor. What is known, is that the
collateral amount posted today will grow to the cash flow at the settlement date, one year from now.
We thus have 2 equations:

(8)

This illustrates that when collateralization is applied, the return on the collateral is the basis for the
discount factor. If this were not the case, there would be arbitrage opportunities.

For cash collateral, the overnight rate on the cash is the discount rate for the derivative, regardless of
the credit quality of the counterparties (the collateralization makes it riskless). For bond collateral, the
discount rate is then the repo rate. This causes a problem, since this rate is generally unobservable, as it
depends on the credit quality of the party borrowing the bonds and the applied haircut, which differs
per transaction. This all depends on the type of bonds used, which is specified in the CSA. Hence the
term CSA discounting.

The most important result is that the funding cost of the collateral determines the discount curve used
to value the derivative. If we translate this to a cash collateralized normal (Euribor) swap, the Euribor
discount rate does no longer apply. The risk free nature due to the collateral is to be captured in the risk
free discount rate, which is the OIS rate. A second curve is thus introduced for valuation purposes. The
pricing formulas (3) and (5) above are then no longer accurate because those formulas only work for one
underlying curve.

When using the OIS curve for discounting on a normal Euribor swap, we have to combine the Euribor
swap valuation with the risk free nature from the OI swaps. For the fixed leg, this results in combining
(3) and (6):

(9)

The fixed cash flows determined by the Euribor curve are discounted with the OIS curve since the
collateral made the swap risk-free.

15
The same operation for the floating cash flows is performed by combining (4) with Eonia discounting:

(10)

The forward rates used to value the floating leg are still Euribor rates while the discounting of this leg is
done using the OIS curve. Note that the simplification to (5) is no longer possible, as the discount factors
used to calculate the forward rates originate from the Euribor curve while the discounting itself is done
with OIS discount factors. This is a direct consequence of equation (8), which states that the growth rate
of the collateral (here: Eonia) is the basis for the discount factors used to value the derivative.

16
 2.4. Bond collateral
Contrary to banks, pension funds do not usually have a lot of cash at hand. They do typically have a large
asset allocation to government bonds, which can also be used as collateral. (Verheijen, 2009) Therefore,
pension funds specify their CSAs such that collateral on both sides is posted in the form of government
bonds. Sometimes, a further specification is added; such as triple A rated only, or only government
bonds from a specific set of countries. The latter has become more important since the euro debt crisis
has resulted in differences in quality as collateral between countries’ government bonds.

Let’s assume that the bank has a negative MtM , and thus has to post collateral, which it does in the
form of bonds. The flow chart then looks like:

Figure 2: Bonds collateral process, after shift in MtM

Money Bond collateral Pension

Market Bank Fund
Cash

Cash Bond collateral

Repo
Market

As stated earlier, banks do not usually have a large portfolio of bonds on their balance sheet. To obtain
the bonds needed for the collateral, the bank lends out cash in the repo market. The repo transaction is
bond collateralized, so the bank receives bonds as collateral for the loan. The financing of this
transaction is still done through the money market, similar to cash collateral. However, the cash is lent
out to the repo counterparty in exchange for the bonds as collateral. (Lansink & Potters, 2011)

During the repo, there is transfer of legal and beneficial title, allowing “re-use”. (Wood, 2011) The bank
is thus allowed to post the bonds as collateral to the pension fund. Even though the legal rights have
been transferred to the bank, the repo counterparty still receives the coupons, just as the pension fund
transfers these coupons to the bank when paid out. Because the value of the collateral drops with the
payout of the coupon, the bank then will post more bonds to take away the credit risk for the pension
fund. The coupons can thus be left out of the valuation process, and will be ignored in the remainder of
the thesis.

17
The amount of collateral is settled on a daily basis, and thus varies during the life of the contract. The
settlement is performed such that at the end of each day, the collateral amount equals the present
value of the contract.12 This will be discussed further below.

Now suppose that one day later, the pension fund wants to unwind the position, thus receiving the
present value of the contract by selling it back to the bank. The process is then reversed:

Figure 3: Bonds collateral process, at unwinding of the contract

PV of contract

Money Cash + 1 day EONIA Pension

Market +EONIA Bank Fund

Bond collateral

Cash + 1 day (EONIA + X%)

Bond collateral

Repo
Market

The bank pays the present value of the contract to the pension fund and receives back the bonds posted
as collateral, and then reverses the repo transaction. The bank receives back the cash plus interest,
being the repo rate. The cash plus Eonia is then used to pay back the financer of the collateral. When the
repo rate equals EONIA, X=0 and the process is basically similar to the one above with cash collateral.
The only difference is the repo market as intermediary to swap cash collateral to bond collateral.
However, X% is a profit for the bank when the repo rate is higher than EONIA13. The total loss of the
contract to the bank is then the present value of the contract it has to pay to the pension fund plus the
gain or loss on the collateral posting, which is dependent on X.

12
In practice, not all MtM is settled daily. When the change is very small, the cost of posting the extra collateral
can become relatively high. Therefore, a minimum transfer amount (MTA) is specified in the CSA. This means that
the position is only settled when the amount that has to be exchanged exceeds the MTA. Obviously, the higher the
MTA, the higher the risk. In this thesis, the MTA is assumed to be low enough not to cause significant credit risk.
13
In theory and in practice, repo spreads can be negative. This has occurred for German government bonds. This is
not market failure, it just reflects the strength of the demand for a security. (Wood, 2011) In this case, the bank
would make a loss on posting bonds as collateral.

18
When bonds are used as collateral, equations (9) and (10) are no longer valid because the collateral
cannot be discounted using the OIS rate (assuming X ). Following (8), the repo rate is then the
relevant rate to use. The forward rates in the floating leg are still based on the curve used, but the
discount factors are now based on the repo rate, which is Eonia + a spread which is unknown.
Regardless of the spread, the pricing formulas would then be transformed to:

(11)

(12)

Since the allowed collateral is specified in the CSA, the practice of discounting with the collateral rate is
referred to as CSA discounting. This is discussed next.

19
 2.4.1. CSA optionality
The above examples assume that the CSA is specified such that one particular way of collateral posting is
allowed. However, frequently there is optionality in the CSA when it specifies that both cash and bonds
are accepted as collateral. The party that has to post will then choose the cheapest way of doing so.
Hence the term cheapest to deliver (CTD) option.

For the example above, if the CSA would allow both bonds and cash as collateral, the bank would choose
bonds when X>0. The bank will pick the allowed bonds with the highest repo rate, which usually is the
lowest rated bond. If the pension fund fails to restrict the collateral to a certain quality, the bank will
profit by posting low-grade collateral in which the pension fund possibly would not normally invest.

Another form of optionality occurs when different currencies are allowed. For example, the CSA can
specify that only Euros, Dollars or British Pounds can be used, or bonds from all of the countries. In this
case, the party that has to post collateral will choose the currency that is cheapest to borrow. The
reason that currency optionality is present is due to a lack of liquidity in some currencies. For example,
there are not enough British government bonds (Gilts) being traded to support all the collateral calls in
Britain’s large financial and pension industries. Specifying the CSA in a very strict way could lead to
higher collateral costs for both parties, which is obviously not desirable. A widely specified CSA does,
however, lead to extra complexity in the valuation of derivative contracts.

This effect is enlarged when collateral substitution is not prohibited. In this case, the CSA allows for daily
substitution of the collateral, meaning that the counterparty in a collateralized contract with a negative
MtM can switch collateral every day. Thus, every day the party will reevaluate what is cheapest to
deliver, and act accordingly. This creates a series of options, one or more for every day until the maturity
of the contract. Sawyer (2011) reports occurrences where dealers have refused requests for collateral
substitution, and concludes that multicurrency CSAs change the valuation of plain vanilla swaps from
simple to very complex. The instruments needed to hedge these exposures or derive pricing from are
not currently traded, so he states that a new standardized CSA may be the only option.

The optionality that can be in a CSA will not be further discussed, as it is not relevant for the research
question. The assumption throughout the thesis is a clearly specified Euro-cash-only CSA, unless stated
otherwise. The reason that bond collateral is only briefly mentioned is that is does not make a significant
difference when the CSA is conservatively specified. If the CSA only specifies AAA rated government
bonds or other very high quality securities to qualify as collateral, ‘the OIS index is generally a good
proxy for the repo rate.’ (Shepley, 2001) This would make X equal zero, and would reduce the
methodology for valuation and hedging to the cash collateral approach. For this reason and the lack of
consistent data on repo spreads, in the remainder of this thesis all mentioned collateral concerns cash
collateral, so that the OIS curve can be used for discounting.

20
3. Curve construction
Now that the valuation of interest rate swaps is sorted out, we can use the results from the previous
section to build a zero rate curve, which are essential for any valuation problem. Since these curves are
primarily built from swaps, we can use par swap quotes to construct a zero curve, based on the
valuation section. How this is done and some related issues are discussed in this section.

3.1. Curve instruments

As visible in the appendix, the shortest two instruments used to build the Euribor curve in this thesis are
the six month and one year cash instruments, while liquid instruments of for example one week and
three months are available. However, since the short end lacks importance in this thesis due to the long
horizons, only these two zero coupon instruments are chosen to build the short end of the curve.

The swap instruments used all have a floating tenor of six months. The reason for this is that many
authors, including Bianchetti (2009), explicitly stress the importance of using curve instruments that are
homogeneous in the underlying rate tenor. This means that the floating side of the swap should be
equal for all instruments. Market characteristics such as liquidity and credit risk premiums are very
different for different floating rate tenors. The fixed-for-3month floating swap market has different
dynamics than the fixed-for-6month floating swap market. This has not always been the case, but the
crisis has ‘segmented the market in sub-areas corresponding to different underlying rate tenors’,
according to Bianchetti (2010).

For the Eonia curve, the floating tenor of all instruments always is a single day, so that no such problems
could arise. All instruments used to build the OIS curve are therefore swaps, being most liquid. Other
instruments could be added to the short end but the effect on the high duration portfolio would be
negligible. To retain oversight, the same instruments are used as for the Euribor curve, except for the
three highest maturity instruments which are not available for Eonia. This is discussed in subsection
3.2.2.

3.2. Curve building14

With the knowledge from the valuation section, market swaps can be analyzed. In particular, the fact
that the value is zero at inception offers possibilities in combination with a market quote. For valuation
of a large set of cash flows at varying maturities, a zero curve is required so that the discount factor for
each cash flow can be derived. The short end of the zero curve, up to one year, is constructed from cash
instruments and is therefore known. However, for longer maturities, the swap market is more liquid
making that a better choice. To extract the zero rate from a swap, we can rewrite equations (3) and (4),
given that the value of the floating leg should equal the value of the fixed leg:

14
Subsection based on Hull (2007)

21
Since the one-year instrument is a cash instrument, we can derive using (1) for Euribor. For Eonia,
only swap instruments are used so that we get:

Since the fixed rate is quoted in the market, the one year discount factor is the only unknown which can
be solved for. From this point on the procedure is the same for both curves, starting from the two year
swap value:

Since we have calculated already, and is the swap rate quoted in the market for the 2-year
instrument, we are left with only one unknown parameter; . We can solve for :

This can be generalized for year swaps up to maturity to:

(13)

This way, we can step-by-step solve for all the discount factors of the curve’s instruments. Using (1) we
can then convert the discount factors to zero rates to obtain the required curve. The process described
above is generally known as bootstrapping.

3.2.1. Curve interpolation

As is visible in the appendix, there are no (liquid) instruments for all maturities. For example, the 13 and
14 year Euribor swap quotes are missing. We then jump to the 15 year quote, but this means that there
are three unknowns and only one equation. However, by assuming an interpolation method, the 13 and
14 year discount factors can be written as functions of the 12 and 15 year discount factors, so that one
unknown is left and the unknown discount factor can be solved for using (13). The method used is
smooth cubic splines interpolation as described in Hagan and West (2006) and will also be discussed in

22
the interest rate sensitivity section. The curve is thus sensitive to two input types; the instrument rates
and the interpolation method. The grid points of the curve where the instruments are located are not
subject to interpolation while the rest of the curve depends upon the interpolation method which
connects the grid points into one continuous curve.

The reason for choosing a smooth interpolation technique over a computationally much less complex
linear or log-linear method lies purely in quality. Even though Hagan and West (2006) state that log-
linear interpolation is quite popular, they conclude that there are multiple problems. The method allows
for negative forward rates, which are not always differentiable and the forward curve suffers from ‘zig-
zag instability’. Also Bianchetti (2009) notes that ‘this still diffused market practice produces zero curves
without apparent problems, but sag saw forward curves with unnatural oscillations in the forward basis.’
For pure discounting purposes the method can thus hold, but since we are treating almost solely swaps
which are valued by their forward cash flows, a smooth bootstrapping technique is required.

3.2.2. Curve use

Once a curve is built, any cash flow at any future time can be properly discounted. For cash flows with a
maturity of more than 50 years, the 50 year zero rate is assumed, implying flat extrapolation of the zero
rates. This is done due to lack of better alternatives, and the observation that very long term rates
correlate strongly.

An Eonia zero curve can also be built using the procedure above, as OI swaps are only dependent on one
curve even though the contracts are collateralized. The swap and forward quotes are indeed retrieved
from the Eonia curve which is also used for discounting. Recall that (3) and (5) are equal to (6) and (7)
except for the curve used. Inversely, the two different curves can be built using the same method, but
with different instruments.

23
 3.3. Forward adjustment
Since swap quotes for Euribor swaps are set under the assumption of collateralization, a completely
realistic Euribor curve cannot be built in the way described in section 4.1. This is due to the OIS discount
factors in the valuation formula of the swap instruments. However, these OIS discount factors are not
unknown, they can be derived from the Eonia curve built first. Given the Euribor swap quotes, we then
have from (9) and (10) :

For a two year swap this becomes:

Since all the OIS discount factors are known from the Eonia curve, only the forward rates are unknown.
The short end of the Euribor curve is derived from cash instruments, so the first 2 forward rates are
given. By then interpolating between the one and two year forward rate to obtain as a function
of and , only the last forward rate is unknown. This way, we can again use a step-by-step
procedure to obtain all the forward rates. We then have all the parameters required in (9) and (10), and
thus we can value a collateralized Euribor swap.

The implied forward curve obtained this way is slightly different than the forward rates calculated using
(2). This is due to the fact that even though both legs are discounted with the same, but now lower
curve, the distribution of cash flows over time is not exactly equal. The present value is the same at
inception, but the payouts occur yearly for the fixed leg and semi-annually for the floating leg. Also, the
forward rate could be below the fixed rate during the first years of the swap and above the fixed rate in
later years, or vice versa. As a result, the forward curve obtained using (2) is recalibrated using implied
rates from the swap quotes. Mercurio (2009) accounts for this difference by using forward rate
agreements to determine the forward rates and then discount these using the OIS curve.

In the next chapter, the interest rate sensitivity of a swap is determined. The forward adjustment
described here is not taken into account, as the computational difficulties outweigh the benefit from a
more exact approach. The expectation is that the minor adjustment resulting from this more refined
approach will only show up as unidentifiable noise on the funding ratio level. It is therefore ignored, so
that (2) can be used in both the valuation and sensitivity calculations.

24
4. Interest rate sensitivity
Present values of future cash flows are discounted using a curve built as described in the previous
section. This present values are thus sensitive to the discount curve. If the future cash flows itself are
also dependent on a curve, which is the case with a swap, there is a second base of exposure to that
curve. The curve itself has sensitivity to the instruments with which it is built, as described in the
previous section. The goal of this section is to identify the exposure of any claim on future cash flows to
the curve instruments. This information is a prerequisite for being able to hedge the exposure.

For small parallel shifts the modified duration, which is the change in present value of the claim as a
result of a one percent parallel shift in the interest rate curve, is appropriate for determining the interest
rate sensitivity of an IRS. However, since interest rates also shift separately from each other, a more
refined approach is advisable. The sensitivity can be determined to each grid point on the interest rate
curve, where the grids represent the instruments used to build the curve. The method the curve was
built with determines the sensitivity of a cash flow to that curve. Thus, the calculation of the sensitivity
is done according to the method used to build the curve. This results in reporting zero deltas to the cash
instruments, while reporting par swap rate deltas to the swap instruments. The whole procedure is
illustrated using a two year swap example, combined with a curve which has only two instruments, a
one and a two year swap. Where relevant, the effect of using a cash instrument instead of a swap
instrument is discussed. The two year swap will be illustrated numerically as well as in formulas. For
every important result, the generalized formula is presented and numbered.

First, the sensitivity of a single curve swap is derived, for Euribor and OI swaps. The results will then be
used as the basis for deriving the sensitivity of a collateralized Euribor swap to both relevant curves.

4.1. Single curve interest rate sensitivity15

The sensitivity of a product is calculated with respect to an interest rate curve, which in turn is sensitive
to the rates of the underlying instruments. We thus want to calculate the sensitivity of a product to the
curve’s rates; this is done by defining the sensitivity of the value of a contingent claim C to every rate
as (using the chain rule):

Note that depends on the instrument used. This could be a zero rate or a swap rate.

15
Derivation based on Lord (2009)

25
Since we want to know the sensitivity with respect to the whole curve, and thus all the instruments, we
switch to matrix notation, where the under bar depicts the vector property of the variable:

(14)

The sensitivity of the claim to the n rates equals the product of the m replicating flows16 of the claim and
a Jacobian17 matrix with the sensitivities of the discount factors to the underlying instrument rates. The
left-hand side is a row vector of sensitivities to all the instruments’ rates, which is a result of the row
vector of repflows multiplied with the Jacobian. The claim that we are going to investigate is a two year
uncollateralized interest rate swap with a notional of 100. Recall that the value of a two year receiver
swap is determined by the fixed leg minus the floating leg. As it concerns a quoted swap, this means that
the fixed rate is exactly set to make the total value zero. This results in the two year claim18:

For our illustrative example, the following applies:

 The curve is built from two swap instruments:

o 1y 4%
o 2y 5%
 As a result, as this is the two year swap rate quoted in the market
 N=100
 For simplicity, the alphas are assumed one.
 The discount factors can be solved for using the curve build section(3.2):
o
o

This means we have all the required parameters. We can then take the derivative of the value of this
claim with respect to its discount factors to obtain the replicating future cash flows, referred to as
repflows in this thesis.

16
The present value of a cash flow is the product of that cash flow and its discount factor, + the initial investment.
The derivative to the discount factor thus only leaves the future cash flow, defined here as replicating flow or
repflow. (except for the derivative to , which will leave the initial investment. The investment is not present in
the matrix, as it is not relevant, it has no interest rate sensitivity.) This holds true for linear products, which is
suitable here as only plain vanilla swaps are discussed in this thesis.
17
A Jacobian matrix is the matrix of all first order partial derivatives of a vector with respect to another vector.
18
Because all day count fractions relating to the floating side drop out for all sensitivity calculations, all the alphas
shown are fixed leg alphas with annual periods.

26
This can be put together in a row vector. The notional will be ignored in the generalized formulas in an
attempt to maintain oversight:

For the example swap, this comes down to:

To make this intuitive; recall that a swap is basically a fixed rate bond minus a floating rate bond. A
floating rate bond has no or minimal interest rate sensitivity, all intermediate payment terms drop out
already in the valuation section. The discount exposure of this swap can be described as the nominal
coupon payment in one year and the coupon plus notional in two years. The numbers should be
interpreted as the following: Any increase in the one year discount factor directly results in a five times
as big an increase in the present value of the swap, any increase in the two year discount factor is
immediately followed by a 105 times as big an increase in the PV of the claim.

The above can be generalized for discount factors with subscript :

(15)

Note that only the last cash flow has the added ‘1’, representing the notional of the embedded fixed
rate bond.

What is described here is the sensitivity of the claim to the discount factors, while the latter only
changes as a result of a change in the rate of the underlying instrument. What is required is thus the
sensitivity of the discount factors with respect to the underlying rates. This will be discussed below.

4.1.1. Intermezzo: Cash instrument

Now that when (the replicating flows) are known, the sensitivities of the discount factors to the
interest rates represent the only unknown in (14). If the one year instrument would be a zero coupon
bond instead of a swap, the derivatives can simply be taken from (1):

We then take the derivative with respect to all the zero rates:

27
For zero coupon instruments, which are the cash instruments used here to build the curve, there is no
cross-sensitivity with other rates. Therefore, derivatives to other rates are zero, just like the derivative
to the two year rate here.

4.1.2. Swap instruments cont’d

Unfortunately, the derivative of the discount factor to the respective instrument rate is not directly
derivable for swap instruments. The relation described in (1) does not hold for the swap instruments, as
zero rates are not the same as swap rates. There is a way around this, however. Relation (14) also holds
for the instruments used to build the curve. We can thus write the swap instrument’s present value
sensitivity to the underlying swap rate similarly to the claim’s sensitivity:

(16)

Note that the PV here refers to the present value the swap instrument, which is similar to the claim C of
which we are trying to calculate the deltas. The deltas calculated here are par swap deltas, contrary to
the zero deltas which were calculated in de the cash instrument section. then refers to a vector of
swap rates. Equation (16) can be rearranged by multiplying both sides with the inverse of the repflow
matrix:

(17)

The matrices on the right hand side can both be derived for both the instruments. For the one year swap
we have the instruments’ repflows similar to the repflows of the claim C:

For the two year swap instrument we then have:

28
This can be put together in a square matrix:

For simplicity we take a notional of 100 for these instruments too regarding the example, which results
in:

This matrix represents the replicating flows of both the instruments with respect to both the one year
and two year discount factor. The middle term of (17) is now known. The third term from (17) can also
be derived from the swap valuation formulas. We then take the derivative of the PV of both the one and
two year instrument with respect to the fixed rates instead of the discount factors.

For the one year swap:

For the two year swap:

This results in a diagonal matrix, as there is no cross-sensitivity here:

For our example, this results in:

29
Note that the numbers are multiplied by the notional of 100 here. It then becomes clear that the
derivative to the fixed rate of a swap results in the sum of the discount factors needed to discount all
future payments. (Multiplied by the notional) The floating side drops out which basically leaves a stream
of fixed cash flows that only have discount exposure. With these results, the Jacobian of the discount
factors to the swap instrument rates can be generally defined with denoting the instruments as:

For both matrices, the diagonal contains the information regarding the sensitivity of the instrument with
its own grid point. Note that there is no cross sensitivity in the present values to the rates, but that the
middle matrix makes clear that swaps with longer maturities have exposure to the shorter maturity
discount factors. This pictures the discount exposure the fixed payments contain.

Note that the result above only holds for curves built completely from swaps. Given that the curve used
in this thesis is built from cash instruments up to the one year point, the top rows can be replaced with
the cash instrument derivatives described in the cash instrument section.

This result can be plugged in equation (14) :

(18)

Equation (18) shows that all the terms can be derived now. For our example, we can first calculate the
sensitivity of the discount factors with respect to the underlying par swap rates:

we can now calculate the deltas by multiplying the repflows with this result:

This result is the answer to the original question: what is the sensitivity of the present value of the claim
to the yield curve? As it turns out, the one year rate has no influence at all, while the present value of
our two year par swap with notional 100 will decrease by 1.86 cents if ceteris paribus the two year par
swap rate goes up with one basis point. (So from 5% to 5.01% in this case)

30
From the start, we have been analyzing a receiver swap, meaning that the valuation and sensitivity have
been viewed from the party that pays the floating rate and receives the fixed rate. The value of the
contract is then the fixed side minus the floating side. If the perspective of the counterparty is to be
analyzed, the valuation formula changes to floating minus fixed. The only relevant change is the minus
sign, which then appears for the fixed leg instead of the float leg. All signs above are then reversed and
the final answer would be that the swap increases 1.86 due to a one basis point increase in the swap
rate. This is true by definition, as the value of the contract to one party should always be the opposite of
the value of the same contract for the counterparty.19

4.1.3. Interpolation
The approach considered makes one unrealistic assumption, namely that all cash flows of the contingent
claim occur exactly on the grid points of the curve where the instruments are located. Cash flows should
be able to occur at any point of the curve. If this is the case, the rate is interpolated between the grid
points using smooth interpolation, identical to the curve build.

We then get an additional derivative, that of the discount factor of the cash flow at time to the
discount factors of the nearby grid points. We account for this by redefining the Jacobian:

(19)

Here represents the exact time of the future cash flow, so that Is the vector of discount factors
for all payment dates. The term then only contains the discount factors on the grid points of the
curve, where the instruments are located, so that we get an interpolation matrix containing the
sensitivities of all relevant discount factors to all discount factors on the grid points. This is required to
calculate the sensitivity of the present value of the claim with respect to the instruments’ rates.

Recall from (5) that the intermediate floating payments dropped out in the valuation formula using one
curve. Therefore, no interpolation is required when valuing a swap on its start date. However, if the
swap started in the past, the fixed payments will often not occur on the grid points, and thus
interpolation is required if for example the hedge has to be rebalanced.

We introduce an interpolation term which defines the sensitivities of the pay date discount factors to
the grid point discount factors of the instruments. Suppose the 2 year swap started 6 months ago but
we want to know its deltas today (with the value of the contract still zero). We then have two replicating
flows, in 6 months from now and in 18 months. The first flow only has exposure to the one year
instrument, albeit partially, and the second flow is influenced by both the one and two year instrument.

19
In practice, there can be disagreement between the two parties about the value, for example due to different
curve building techniques used, which can have an impact on the valuation. The value is then renegotiated. This
possible inequality is ignored in this thesis.

31
The function of the interpolation matrix is thus to divide the cash flow sensitivities to the corresponding
discount factor to all the instrument discount factors:

The full derivation is not provided, as it is beyond the scope of the thesis here. The method used is
cubic-splines interpolation as described in Hagan and West (2006).

Since the example curve used in this section only has two instruments, and the replicating flows of the
two year example swap occur exactly at the instrument maturities, the interpolation matrix will have no
impact.(It will be an identity matrix) An example explaining this will be given later on.

The interpolation term can be integrated in (18) by applying the chain rule:

(20)

The result is an analytic solution for the sensitivity of any cash flow to any rate on the curve, defined as
the change in value of the contingent claim as a consequence of a one basis point change in the
respective rate. This is the single curve solution which is used to set up hedges to Euribor without taking
a separate discount curve into account. We will now turn to the two-curve solution where the OIS
discount curve is explicitly accounted for.

32
 4.2. Double curve interest rate sensitivity
Recall from the valuation section that collateralized swaps are discounted with the OIS curve. Therefore,
the valuation formula to derive the interest rate sensitivity from is for a collateralized two year swap
given below. The claim C is the same as in the previous subsection, but now it is collateralized. We use
the double curve valuation from (9) and (10):

We can rewrite the forward rates using (2):

As in the valuation, the alphas on the floating side drop out20:

Removing the brackets we get:

For the sensitivity to the Euribor discount factors we then see that the fixed leg drops out completely, as
that leg only has discount exposure. This exposure is to be captured in the derivation to the OIS discount
factors. The floating leg is of course dependent on Euribor, while the cash flows emerging from this leg
are also discounted with the OIS curve.

Bianchetti (2009) states in his presentation at the Quant congress that ‘delta risk with respect to both
curves [i.e. the forward and the discount curve] should be calculated in order to determine the delta of

20
The Day count convention (DCC) of EONIA is ACT/360, for both the fixed and floating leg. Since the floating leg of
Euribor swaps also has this DCC, this turns out to be convenient when rewriting the forward rates; the alpha term
denoting the DCC then drops out similar to the uncollateralized case.

33
any portfolio of interest rate derivatives.’ So what is required is a split of the sensitivities of the claims to
both curves. We thus rewrite (14) in two ways21:

(21)

(22)

The terms of interest are the repflow terms in the middle as the instrument sensitivities on the right
hand side are already explained in the previous subsections. We already know the sensitivities of the
discount factors to the instrument rates, as these can be derived for both curves using (16).22

However, the example was only performed for the Euribor curve. Note however that the valuation of an
OI swap is performed equally to that of a normal IRS except for the underlying curve. (Compare (3) and
(5) with (6) and (7)) This means that the method to determine the derivatives is also equal, but that the
input parameters are different. For illustration, we use the following instruments:

Table 1: Curve instruments

EUR swap curve instruments OI swap curve instruments
1y 4% 4%
2y 5% 5%

Indeed, we use two identical curves, but we will now separate the forward and the discount exposure,
to determine the order of magnitude of the two deltas.

Given that both curves are built from the same instruments, the instrument discount factor sensitivities
are equal to the single curve case:

The difference is going to be in the repflows, which we will now determine below separately, starting
with the sensitivity of the collateralized claim to the forward curve.

21
We switch notation; from now on, the superscript ‘EUR’ is added to all Euribor (forward) terms, while the Eonia
(discount) terms retain the superscript ‘OIS’ in order to avoid confusion.
22
This is true when the Euribor swap instrument is quoted as uncollateralized.

34
As the fixed leg has no exposure to the forward curve and thus drops out in this derivation, the
sensitivity is determined for the floating leg which has the value23:

The floating leg then has the following sensitivity:

These results can be put together in a vector. Note that the derivative is to the cash flow discount
factors, not yet to the instrument discount factors, since there are no semi-annual instruments.

This vector represents the Euribor forward replicating flows. The same vector should be determined for
the (Eonia) discount curve. Both legs have OIS discount exposure, resulting in the following:

23
The minus sign is to illustrate the point that we are still working on a receiver swap, which value is determined
by subtracting the float leg from the fixed leg. As only par swaps are used, the two legs have equal value because
the total value of a par swap is zero by definition.

35
These results can also be put together in a vector:

The two repflow vectors can be generalized for n cash flow tenors of six months with subscript to:

(23)

(24)

These same vectors can be calculated for our collateralized two year swap example, as all the terms are
known. The results are simply presented:

The most obvious difference is the large exposure to the highest maturity discount factor of the forward
curve, which is much smaller when regarding the discount curve. The two negative value in the OIS
derivation concerns the two (negative) floating payments, which have opposite discount exposure than
the positive (netted) cash flows on the full-year points.

Now that we have the repflow vectors for both curves, we can use this in (21) and (22). However, the
repflow vectors contain 4 elements for a period that only has two instruments on the curve. We thus
have to add the same interpolation term as in (20). Even though it now concerns a floating payment
instead of the fixed repflow in (20), the method does not change as the goal is still the same:
determining the sensitivities of the repflow discount factors with respect to the grid point discount
factors. Therefore we can simply add (19) to (21) and (22). The result from (17) is also added so that we
end up with the full two curve interest rate sensitivities:

(25)

(26)

These two results will be the main tools in determining the optimal two-curve hedge in the empirical
part, as the deltas calculated with the above are the exposure that has to be hedged.

36
If we run this procedure for the two year example swap, we have to add the interpolation term first.
Here the interpolation matrix for both repflow vectors is presented, as deriving it is beyond scope here.

Recall that there are only two instruments, a one and two year swap. There are four cash flows with
sensitivities, every six months, which are all discounted using a discount factor. The second and fourth
row thus represent the full year discount factors, which occur on the grid points on the curve where the
instruments are located. Therefore, the second row has a one to depict the perfect sensitivity to the one
year instrument discount factor and a zero because the two year instrument has no influence in that
point. The fourth row represents the two year cash flow which only has (perfect) sensitivity to the two
year instrument discount factor. The first row concerns the six month payment, which has only
sensitivity to the one year discount factor. (The zero-year interest rate is zero by definition, and is left
out). The third row depicts the sensitivity of the 1,5 year discount factor which is determined by the two
instruments’ discount factors, more so by the one year swap instrument.

Now we have all the input needed for equation (24) and (25). The interpolation matrix converts the
repflow matrix to the right dimension, so we get:

This shows some interesting differences with the single curve situation, which is again depicted below.

Note that the single curve repflows are the sum of the separate curve repflows. We can thus conclude,
that if

In other words, if the discount and forward curve are built from the same instruments, the curves are
identical and their separate repflows sum up to the single curve repflows.

37
The same holds for the deltas; we keep the repflows separate and multiply them with the sensitivity of
the discount factors to the rates to obtain the deltas24:

Recall the single curve deltas, which match the sum of the separate deltas:

The delta to the lower maturity instruments is non-zero but small if taken separately for discount and
forward exposure.25 There is also a clear separate exposure to the OIS curve to the highest maturity
instrument, albeit much smaller in magnitude compared to the forward curve delta. Note however that
this is a short swap, and that the discount exposure becomes larger relative to the forward exposure for
longer maturity swaps.

The next subsection will show the additive property symbolically.

4.2.1. Validation
The results in (23) and (24) can easily be validated by taking the same instruments for both curves. So
suppose that the discount curve and the forward curve are exactly equal in each point, because the
curves are built from the same instruments. The superscripts then drop out, as the OIS curve = EUR
curve so the discount factors are also equal.

This can be reduced to :

(27)

24
Somewhat more decimals are used her to show the non-zero nature of the lower maturity sensitivities. Of
course, a higher notional could have been used, but that would create the same problem elsewhere in the
calculation.
25
The forward exposure is positive contrary to the negative exposure on the last instrument, but that is not the
general case. When 20 instruments are used, the shorter maturity instrument deltas can have both positive and
negative signs, depending on the curve.

38
We do the same to the OIS repflows:

(28)

We can thus add the (27) and (28) to obtain:

The zeros in the above vector represent sensitivity to semi-annual points, which played no role in the
single curve case. For the two year swap case, the interpolation matrix would be:

All the rows representing a semi-annual cash flow only have zeros. If we then multiply the summed up
repflows with the matrix with the appropriate dimension, the zeros in the repflow vector drop out and
we get:

This is exactly equal to (15), the repflow vector in the single curve case.

This can then be multiplied with the instrument sensitivities to the rates, which are equal for both
curves since the curves were set equal;

We can thus conclude that when the Euribor-Eonia spread is zero at every point in the curve, the two-
curve approach delivers the exact same results as the single curve approach.

This result justifies the methods used in the past, as the spread was negligible before the crisis (check
graph 1) and both methods would have delivered the same deltas, resulting in the same hedge strategy.
This is also pointed out by Mercurio (2009) who refers to the OIS curve before the crisis as chasing the
swap curve making the spread negligible.

39
The results above, however, do outline the need for a two-curve approach when the Euribor-Eonia
spread is significant. (25) and (26) cannot be added up in this case so the distinctive approach is
methodologically advisable. One could argue that which is indeed the case, and this is exactly
what is captured in the forward adjustment described in the curve build section. The influence,
however, is so small that it is ignored. Another statement that can be made is that the correlation
between the two curves is so high that a completely separate treatment misses an important
parameter. This is discussed below.

40
 4.2.2. Intermezzo: Correlation
As quoted before, Mercurio (2009) stated that swap rates of the same maturity but different underlying
rate tenor would chase each other on a negligible spread before the crisis, so that a separate treatment
would make no sense. However, this correlation is no longer equal to one, not even if calm times return.
As Bianchetti (2010) noted, the fact that the OIS market has a different underlying rate tenor than the
Euro swap market, makes them segmented. This does not mean that the correlation cannot be close to
one, but there are different dynamics at work.

Another reason for not taking into account the correlation is that institutions that want to hedge
interest rate risk do so to protect themselves against extreme events. Exactly in these extreme events,
the correlation will be far from one so that any hedging strategy based on static correlation will not
perform very well. Graphs 3 and 4 on the next page show that this is the case.

Graph 3: 6month Euribor vs 6m Eonia

Graph 4: Correlation 6m Euribor swap rate with 6m Eonia swap rate (3 month backwards rolling level average, so t-3m to t)

41
A hedging strategy for stress scenarios should not be dependent on variables that behave differently
during stress events. It is clear that the correlation between the two curves is very unpredictable and
varies across the full range from minus one to one. There is also no indication that the old times with a
stable correlation close to one is likely to return in the near future, just as it looks unlikely that the
spread will completely close again. Any assumption made about future correlation to build a hedge with
is therefore futile, which is the reason that it is completely left out of this thesis.

There are two risks that should be hedged; the future nominal floating payments vary with the Euribor
curve, while both the fixed and floating payments are exposed to the OIS discount curve. We will thus
proceed in a setting where the sensitivities to both curves are calculated separately in order to optimally
determine the exposure. This will give the best starting point for hedging.

4.2.3. Double curve sensitivities cont’d

If we lower the discount curve while keeping the forward curve equal, we get the situation where the
double curve approach is more appropriate. We again follow equations (25) and (26).

Table 2: Curve instruments with non-zero spread

EUR swap curve instruments OI swap curve instruments
1y 4% 3%
2y 5% 4%

We repeat all calculations done in the sensitivity section, but now with a lower discount curve. We start
with the instrument sensitivities:

Note that the OIS instruments now have higher sensitivity. This is caused by the lower curve, which gives
the present value of all cash flows of the OIS instrument a higher value.

The repflows change for the derivative to the forward curve discount factors, while the OIS repflows
remain constant. This is due to the OIS discount factors in the forward curve repflows, as shown in (23).
At the same time, (24) shows that the OIS repflows do not contain any OIS terms.

42
The interpolation matrix for the forward curve remains constant contrary to the OIS one. This is caused
by different discount factors that partly determine the interpolation matrix:

We can then multiply the repflows with the interpolation matrices to obtain the sensitivity of the
present value of the claim to the instrument discount factors. We then get the instrument repflows:

Note that these vectors do no longer add up to the single curve equivalent, which had 5 and 105 as
values. This also translates into the deltas, which are obtained by multiplying the above with the
instrument sensitivities.

The sum of these deltas is quite different from the case with two equal (and thus one) curves, which is
repeated here for comparison:

Regardless of the fact that the outcomes do not match, these two delta vectors are no longer
theoretically additive. They represent sensitivities to different curves.

The results from this section are the main input for setting up hedges in the next section. Whether the
double curve methodology can be used to improve the existing single curve hedging methods, is to be
discussed in section 6.

43
5. Application in a Pension fund
Now that the required valuation and sensitivity tools are defined, we can point our attention to the
second part of the research question: the effect of collateralization on the users of swap curves, where
the focus lies of institutions which operate in an asset- liability management context such as insurance
companies and pension funds. The latter is picked out due to its importance in the Dutch financial
sector.

The users will need the curves primarily for discounting and hedging purposes, so that will be the
settings in which we will operate. In the remainder of the thesis, all practical issues will be illustrated by
using the hypothetical Dutch defined benefit pension fund xyz. The asset and liability data are from a
real pension fund but have been anonymised and aggregated in broad asset classes.

5.1. Pension fund characteristics

The pension fund has the following balance sheet(in millions):

Table 3: Balance sheet pension fund xyz

Assets Duration Liabilities Duration
Equity € 1,500 0 Pension rights € 3,100 -17.50
Government bonds € 2,100 -11.68 Surplus € 500 0

Total € 3,600 -11.68 Total € 3,600 -17.50

The 42% equity portfolio is not further specified as it is not of interest. We assume the duration of the
equity to be zero, even though this might not be true in practice. However, since all hedging strategies
will be tested under this same assumption, and a non-zero duration would lead to the same adjustment
to all hedges, it is considered negligible. The equity is also kept constant in order to minimize noise in
the results. The effects of this will be discussed in section 5.2.5.

The presence of a corporate sponsor is possible, but there are many real world cases where a corporate
sponsor does either not exist or has gone bankrupt. (Kocken, 2008) Therefore we will proceed with a
standalone pension fund without a corporate sponsor.

The rest of the assets will be referred to as fixed income portfolio, or matching portfolio, which forms
58% of assets. The current funding ratio is 116%, which is above the regulatory level, but lower than
convenient given the volatility of the investments. The surplus acting as buffer could be wiped out in
adverse events, but this risk can be lowered by taking out the interest rate risk with a hedge.

The board of the pension fund has decided to hedge all interest rate risk, and thus needs to know which
positions should be taken in the market to offset the current exposure. For simplicity, it is assumed that

44
the pension fund is closed, so that no new participants can enter and no new rights or contributions are
added. This actually happens regularly, and does not cause any loss in generalizability. (Kocken, 2008)
The liabilities consist of the built up pension rights, which have to be paid out in the future. The
distribution of nominal liabilities is illustrated in graph 5:

Graph 5: Nominal liability distribution of pension fund xyz over time

25
Nominal Liabilities
Millions

20

15

10

0
2007 2014 2020 2027 2034 2040 2047 2054 2060 2067 2074 2080 2087 2094 2100

The graph makes clear that the maximum yearly payout will be reached in 24 years from the startdate,
with an afterwards steadily declining payout until 90 years from now. However the payouts in the near
future also have a large magnitude, and in present value terms have more impact:

Graph 6: Distribution of present value of liabilities of pension fund xyz over time
10
Millions

PV Liabilities
8

0
2007 2014 2020 2027 2034 2040 2047 2054 2060 2067 2074 2080 2087 2094 2100

The present value of the current pension rights is largely concentrated in the coming 30 years. To obtain
the present value, the liabilities are discounted using the Euribor swap curve26, which is mandatory by
FTK regulation in the Netherlands.

Because of the high duration, the fund has a large exposure to the discount rate it uses, and is thus
sensitive to the euro swap curve. However, as shown on the balance sheet, fund xyz has a substantial
fixed income portfolio which partly offsets the sensitivity of the liabilities.

26
The swap curve of 02-07-2007 is used here, as this is the date the hedge is set up later in the thesis. The asset
and liability values are of the same date.

45
This results in the following bucket basis point values (BPVs)27 :

Graph 7: Interest rate exposure fund xyz

2.5
Millions

Total
2.0
Liabilities
1.5 Assets
1.0

0.5

0.0
0-2 3-7 8-14 15-25 26-35 36-45 46+
-0.5

-1.0

-1.5

Graph 7 shows that the exposure is concentrated in the longer maturities, and that the asset cash flows
are concentrated in the middle maturities. The buckets are already defined here, as shown on the x-axis.
The buckets are centered around the most liquid instruments28, being the 2 and 5 year and the 10, 20,
30,40 and 50 year swaps. The exposures are thus summed per bucket, which makes clear that the
matching portfolio offsets quite a big part of the middle maturity liabilities.29 The green bars represent
the exposure that the board wants to hedge, given the assumption that shifts in the rates occur parallel
within the buckets. For example, if the rates in the 36 to 45 year bucket shift downwards by one basis
point, the surplus of the fund would fall by about 1.8 million. A hedge should compensate this effect by
gaining the same value as the loss in surplus.

The buckets are wider for longer maturities, as long term instruments tend to be more correlated than
short term instruments. (Potters, 2011) This statement is supported by the correlation matrix in the
appendix; it clearly shows that longer term rates are more correlated. The 30, 50 and 40 year rates are
nearly perfectly correlated. This could imply that all these rates can be put in one bucket. However,
graph 8 shows that there is quite some variation in the spreads between these rates, implying that
correlation is not a good measure in this case. Therefore the bucket selection is largely the result of
availability and liquidity of the underlying curve instruments.

27
Where the duration is the PV change resulting from a one percent parallel change in the interest rate curve , the
BPV is the PV change resulting from a one basis point parallel change in the curve. A bucket BPV is then the PV
change following a change of one basis point of all rates within the bucket.
28
List of instruments is available in the appendix
29
The sensitivity of the liabilities is shown positively here, while the duration on the balance sheet is negative. This
is because when it concerns the other side of the balance sheet, the fund is basically short the liability cash flows,
and thus the sign flips.

46
Graph 8: Long term Euribor swap spreads in the sample period (in basis points)
0
Jul 2007 Jul 2008
-10

-20

50-30
-30
50-40

-40

-50

The co-movement is obvious from graph 8 but the volatility of the spread, combined with a large
concentration of liability cash flows in the high end of the curve, make that these instruments will be in
separate buckets.

Liquidity also plays a role in the selection, but the two year instrument is not more liquid than for
example the one year. However, graph 7 shows that the interest rate exposure in the short end is so
small that it would not make sense to take out the one year swap separately. The two year instrument is
chosen for methodological reasons; the sample period lasts just under two years and a static hedge is
used. A one year swap would expire halfway the sample so the hedge would have to be rebalanced,
which is undesirable for the testing procedure. Therefore all hedges will be static over the whole sample
period, meaning that no rebalancing will take place.

47
 5.2. Testing methodology
To be able to compare the hedging strategies empirically, they are all tested for effectiveness in a crisis
scenario. Specifically, the test will evaluate the hedge quality during the recent credit crisis. The choice
of a historic event for a stress test has the advantage that ‘these events generally resonate with higher
levels of management, as everybody is aware that these kinds of events actually occurred and that there
is a chance that it might take place again in the future.’ (Kocken, 1997) A randomly generated stress
scenario could be less effective in acting according to the recommendations from the stress test, but has
the advantage of easily increasing the number of scenarios that can be analyzed.

Because of the large potential impact of an interest rate shock to pension funds, which occurred during
the recent crisis, a hedge is set up at the second of July 200730, a day where the crisis was not yet
present in the newspapers or in the Euribor-Eonia spread. The period ends two years later, at June 30th
2009. Goal is to see how different hedging strategies hold up during this period.

Graph 9: Sample period of hedge effectiveness tests, 6m Euribor vs. 6m EONIA

6.0%
Sample period
5.0% Euribor
4.0% EONIA

3.0%

2.0%

1.0%

0.0%
Mar Mar Mar Mar Mar Mar Mar Mar Mar Mar
2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

As can be seen in graph 9, the sample period stretches from one of the last dull moments to the
recovery of a somewhat stable spread, albeit a much larger one than before. This is the scenario for
which the hedge is set up primarily.

The sample period contains 501 business days, for which the interest rates of the instruments of both
the Euribor and the Eonia curve are taken from Bloomberg. The instrument codes can be found in the
appendix. Over the time series, the following parameters will be monitored:

 Volatility/Variance of the funding ratio

 Minimum of the FR during the period

30
The first of July 2007 was a Sunday, so trading was only possible the day after.

48
The board has asked to take away all interest rate risk. This can be translated in a FR volatility due to
interest rate movements of zero. The prime measure for hedge quality will therefore be the variance of
the funding ratio, which should be as low as possible. This is also the only measure that will be
statistically tested, the other one providing secondary information over the hedge. The minimum
funding ratio is particularly interesting for regulatory reasons, as FTK requires the FR to be above 105%
at all times, and a recovery plan with corrective measures when the FR falls below this threshold.

The statistical procedure will be a two-sided F-test for the ratio of two variances of two strategies. The
hypotheses will be that there is a significant difference in variances, where the method which is
assumed to be better(usually the more complicated one), has a lower variance. Whether the latter is
true, is to be found in the results, as the opposite can of course also be true. As we are dealing with
interest rates here, our sample may suffer from autocorrelation. The statistical consequences of this will
be discussed in the limitation section.

5.2.1. Hedge ratio

The hedge described above is a surplus hedge; it is designed to exactly mirror the value change in the
balance sheet of the pension fund in order to keep the surplus constant. This method focuses on the
absolute amount of money in the portfolio, while pension funds are regulated and operated by funding
ratio, a relative measure. A 500 million surplus is very different for a 2-billion Euro fund than for a fund
with 20-billion Euro in liabilities, as the funding ratios will be 125% and 102,5%, respectively. The hedge
ratio, which is 100% for a surplus hedge, has to be chosen with the goal of keeping the funding ratio
intact instead of the surplus. This can be expressed as:

31

In order to keep the FR constant at 116%, the asset side of the balance sheet has to move with 116% of
the percentage change in liabilities. In the above equation, the only unknown is the value of the swaps,
the other variables can be picked from the balance sheet except for the duration of the swaps, which
can of course be picked as required by picking the right instrument. (Or, in the bucket approach, by
properly combining the different instruments) For the notional of the swaps we then get:

(29)

31
We deviate from the bucket approach here by using the duration, for the sake of simplicity. The same approach
can be followed using the bucket method, but in that case by solving a system of equations.

49
This way, a funding ratio hedge can be set up by first inflating the deltas of the liabilities with the
funding ratio, calculate total deltas of the balance sheet and then building the hedge based on these
deltas.

5.2.2. Setting up a hedge: Dividing delta in buckets32

To determine a bucket hedge, a number of steps are performed. Suppose a pension fund has the
following liabilities:

Table 4: Simplified liabilities

1y 1000
2y 1000
3.5y 1250
4y 1500
5y 1500
6y 2000

Given a curve built from cash and swap instruments as described in the curve build section, we then
calculate the sensitivities of these claims using (20)33, which results in table 334:

Table 5: Delta's of the claims to all instruments

6m 0.00
1y -0.06
2y -0.13
3y -0.13
4y -0.65
5y -0.59
6y -0.98
7y 0.00

The right column shows the delta to each instrument; a one basis point rise in the one year swap rate
would lower the present value of the claim portfolio by about six cents. The sensitivity of the cash flow
in 3.5 years is basically divided over the three and four year instrument. What is noticeable is that the six
year delta is much higher than the one year delta, even though the underlying amount is only twice as
big. This shows that longer maturities translate into higher deltas.

We could, of course, now inflate (or deflate) these deltas as described in the previous subsection, but
we assume here that the asset side has exactly the same value as the liabilities and is fully invested in
equity. The hedge ratio is then 100% and there is no natural hedge in place in the form of a fixed income

32
Based on Hull (2010)
33
The approach is similar for one or more curves. For simplicity, only the single curve case is shown.
34
The calculation is performed for all instruments described in the appendix. The eight year and higher
instruments are not shown here as the delta is zero, like the seven year delta.

50
portfolio. In that case, we now have the delta of the balance sheet to all instruments, which should be
aggregated on the subset of most liquid market instruments according to Bianchetti(2009). The chosen
instruments are then referred to as the hedge instruments.

The sum of the deltas tells how much money is won or lost when the curve moves in a parallel way by
one basis point. In that sense, it is highly related to the definition of duration. A single hedge would be
performed using a four year swap, as that one is most in the middle. But if we use the buckets specified
above in graph 7, only the two and five year instrument qualify and the short and middle rates are
separated. Table four contains the bucket sensitivities. The two year bucket contains all delta up to and
including the two year sensitivity, the five year bucket contains the rest.

Table 6: Required hedge notional calculation

Swap unit
Tenor Claim delta delta
2y -0.196356 -0.000186848 1050.88
5y -2.339233 -0.000436473 5359.39

The swap unit delta column shows the delta of a swap of the bucket maturity with a notional of 1. By
dividing the portfolio delta by the swap delta, the required notional to delta-hedge the bucket is
obtained. The portfolio from table 2 can thus be bucket hedged by taking a position of 1051 in a two
year par receiver swap and a position of 5359 in a five year par receiver swap.

If the pension fund wants a single hedge with a four year swap, basically one bucket remains. In this
case, the sum of all deltas would be the exposure to hedge with the single swap, and this number would
then be divided by the per-unit delta of a four year swap. The notional required for this single hedge
would be the result.

The exact same procedure can be followed with OI swaps, but there are some caveats there, which will
be discussed in section 5.2.4.

51
 5.2.3. Single hedge vs bucket hedge
Under the assumption of only parallel shifts of the whole curve, a full hedge can be implemented with
just one instrument. In this case, the exposure of the claim to all instruments would be summed up and
the notional of the hedging swap is based on this number. The result for fund xyz looks like the
following:

Graph 10: Single swap hedge deltas

3.0
Millions

Unhedged
2.0 Hedge
1.0 Hedged

0.0

-1.0 0-2 3-7 8-14 15-25 26-35 36-45 46+

-2.0

-3.0

-4.0

The 30 year receiver swap used for hedging has a notional sufficient to cover all the sensitivities, the red
bar equals the sum of the blue bars. It is, however, only effective for parallel shifts. The graph makes
clear that the hedge is ineffective for non-parallel curve changes or shifts in separate maturity buckets.
Also, if only the 30 year rate changes, the fund is massively over hedged, which leads to extra volatility,
opposite to the goal of the hedge. The problems described here can be greatly mitigated using the more
refined approach of bucket hedging. The assumption of parallel shifts is weakened by only assuming
parallel shifts within the bucket, as explained earlier. Of course, the best possible hedge using this
method is achieved by bucketing per instrument. However, this is often not possible due to lack of
liquidity of some of the instruments. Also the cost-effectiveness can be an issue, but that is beyond the
scope of this thesis. If the bucket hedge approach is followed, the result is a more intuitive graph:

Graph 11: Bucket hedge deltas

2.5
Millions

Unhedged
2.0
Hedge
1.5
Hedged
1.0
0.5
0.0
-0.5 0-2 3-7 8-14 15-25 26-35 36-45 46+
-1.0
-1.5
-2.0
-2.5

52
When the seven buckets are treated separately, the hedged positions have zero delta exposure in the
model. In the short term buckets, the exposure is opposite to the long buckets, because the assets
dominate the liabilities with respect to interest rate sensitivity. Since the board has elected to take away
all exposure to the interest rate, this opposite position also has to be hedged. This is done using three
(small) payer swaps. The four highest maturity buckets are hedged with four receiver swaps. This way,
the delta interest rate exposure is reduced to zero on the bucket level. Note that in both graphs 10 and
11, the adjusted liability deltas have been accounted for. Total delta is therefore somewhat higher than
in graph 7, where the intrinsic balance sheet exposure is shown.

5.2.4. Eonia liquidity

Trading of short Eonia swaps has been around for 12 years, while the middle maturities up to ten years
were added in 2005. The curve was only extended to 30 years on 28 th of May 2008, while the 50 year
instrument was added in April 2011. This means that for about half of the sample period, Eonia data is
missing. In an attempt to reconstruct the long end of the OIS curve for the first half of the dataset, the
Eonia-Euribor spread for all instruments of 10 years maturity or higher is determined on every day both
rates were available. All these spreads are then divided by the 10 year Euribor-Eonia spread of the same
day, which serves as a reference as the longest maturity instrument being traded over the whole sample
period. The outcome is the instruments’ spread as a percentage of the 10 year spread. This percentage
is then averaged over all days, and is shown in table 7:

Table 7: Average Euribor-Eonia spread as percentage of 10 year spread (28-05-2008 to 30-06-2009, 279 business days)
11y 12y 15y 20y 25y 30y
98.02% 95.33% 89.65% 83.97% 80.16% 77.72%

The table shows that the absolute spread is smaller for longer rates. The Eonia rates for the missing data
points are then generated as:

So the OIS rate on a particular day is the Euribor rate minus the 10 year Euribor-Eonia spread multiplied
by the predetermined spread average for that maturity. This way, the dataset is made complete up to
the 30 year point. We cannot calculate the spread average for the rates higher than 30 years, as these
were not available within the sample period. Therefore, the 30 year Eonia zero rate is extrapolated flat
for the whole sample period, similar to the flat extrapolation performed on the Euribor curve from the
50 year point onwards.

The fact that the Eonia swaps have not been trading as long as Euribor swaps extends to a lower
liquidity in the overnight market. Goldman Sachs (2008) describes the OIS market as liquid up to two
years. They do add the expectation that the long dated OI swaps market will develop in the future. Also,
‘the development of an OIS option market is inevitable.’ This means that at this point the middle and
high maturity Eonia swap market is not liquid enough for a somewhat large pension fund such as fund
xyz. There is definitely by far not enough liquidity for all pension funds, so the tradability will be low.
Regardless, an attempt to hedge Eonia exposure with OI swaps is made, but the feasibility of this in the
market is not present today. It is, therefore, a theoretical experiment. It will take regulation and some

53
large parties to make the OIS market sufficiently liquid, and there is a chance that will happen. This is
the reason why the Eonia swap hedge is considered in section 6.

5.2.5. Cash account & equity

During the sample period, the fund is in normal operative status, and thus has to pay out pensions every
month. Also, fixed income investments pay out coupons and mature. Any hedge strategy is built from
swaps, which make reset payments every six months. All these cash flows have to be accounted for. This
is done using a cash account, which can be both positive and negative. If it is negative, it means money is
borrowed, if it is positive, the money earns interest. Borrowing and lending is done at the Eonia rate of
that day. This approach is taken in order to prevent reinvestment issues with maturing bonds and asset
allocation distortions. The cash account is added to the assets every day, so that the surplus and funding
ratio are calculated taking the operating cash into account. This way, the effect on the results should be
minimized.

The same can be said of the assumption that the equity remains constant. This assumption causes the
FR to drop over time because the liabilities are larger than the fixed income portfolio, while the present
value of both amounts grows over time. This is even the case then interest rates stay constant over the
sample. Of course the equity is normally expected to grow also, but is we were to add a drift with a
random component to the equity portfolio the (FR volatility) results would be distorted. Another option
would be adding the equity to the cash account on day one and letting it grow with daily Eonia, but
given that the Eonia curve changes during the sample differently from the Euribor curve used to
discount the remainder of the balance sheet, this would not solve the problem. Also, given the crisis
during the sample, holding equity constant is already optimistic, let alone growing equity. The whole
asset class could of course be dropped and assume fixed-income assets only, but nowadays it is hard to
find such a pension fund.

Given that the FR volatility should solely reflect the effects of interest rate changes, the equity is
assumed constant. Adding a constant to every component of a time series does not change the variance
of that time series, which makes this method the best way of comparing different hedging strategies.
Since all strategies suffer from the same downward trend of the FR, they are comparable without bias.

54
 5.2.6. Sample period events
The situation the hedges have to cope with is illustrated in graph 12. It pictures the interest rates of the
high maturity instruments35 over the sample period. The interest rates drop 200 to 250 basis points
before bouncing back to a level around 4%. Note that the basis spreads rise sharply during the period
and do not recover to the low levels as before.

Graph 12: Euribor long interest rates

5.00%

4.50%

4.00%

3.50%
20y
3.00% 30y
40y
2.50%
50y
2.00%
Jul 2007 Jul 2008

This event causes the liabilities to greatly increase in value; remember from the balance sheet that the
duration of the fund is about 17.5 years. This should thus result in an around 40% increase in the value
of the liabilities. Graph 13 shows that the liabilities increase by more than 50% before falling again,
which pictures the convexity effect. This is the effect that the duration is not constant over different
levels of interest rates, immediately showing a disadvantage of delta hedging.

Graph 13: Assets and liabilities of fund xyz during the sample period

5000
Millions

4500 Assets
Liabilities
4000

3500

3000

2500
Jul 2007 Jul 2008

35
The shortest three bucket instruments are not shown here, since their delta exposure is very small compared to
the other four, and has the opposite sign due to the natural (over) hedge from the fixed income portfolio.

55
What a surplus hedge should do, is exactly mirror the movement of the surplus of the fund, being the
difference between the assets and the liabilities. Graph 14 shows how the simplest hedge, a single swap
in a single curve setting with a hedge ratio of 100%, performs in this task.

Graph 14: Hedged surplus of fund xyz

800
Millions

600

400

200

0
Jul 2007 Jul 2008
-200 Unhedged Surplus
Single swap hedge
-400
Hedged surplus
-600

If the hedge were perfect, the green line would be a straight line without any bumps.36 It is clearly not,
which shows that improvement is still possible. Whether this can be achieved with a static hedge is to be
analyzed in the next section. A dynamic hedge might do better but all hedges are static to make them
comparable. If the board of a pension fund or corporation wants to take away its interest rate exposure,
it wants an effective hedge. The result section therefore tests the performance of more complicated
hedge strategies.

Recall from subsection 5.2.1 that the real testing is performed over funding ratio hedges, not over the
surplus hedge used in graph 14. The surplus hedge is used only for illustrative value in showing how to
counter the effect of decreasing interest rates on the value of the liabilities. All hedges shown in the
results will be funding ratio hedges, as hedging the FR is the goal here.

36
Remember that it would not be horizontal, due to the downward trend explained in the cash account section.

56
6. Results
By using the methodology discussed in the sections three through six, the results are generated and
presented below. The results will cover a number of hedge strategies, which are all analyzed over the
sample period from graph 9. The strategies to be discussed are:

1. No hedging
2. Single curve hedging (Only swap deltas to Euribor curve)
a. Euribor discounting of derivatives
i. Single swap hedging
ii. Bucket hedging
b. OIS discounting of derivatives
i. Single swap hedging
ii. Bucket hedging
3. Double curve hedging (Swap deltas to both the forward curve and the discount curve)
a. Euribor bucket hedge with swap notionals adjusted for two curves
b. Bucket hedge to two curves

The first strategy speaks for itself; the others will be judged based on the performance compared to not
hedging and compared to each other. The most interesting pairs will be picked out, where three
questions pop up as most important:

 What is the difference caused by faulty Euribor discounting where OIS discounting is required?
In other words, to what degree can a pension fund be harmed by using the wrong discount
curve for its derivatives?
 Does bucket hedging outperform hedging with a single swap?
 Does the split of sensitivities improve the quality of the hedge? This can be divided over two
cases; the case where only the notionals of the Euribor swaps are adjusted for OIS discounting
and the case where OI swaps are added to the hedge in order to hedge the exposure to the
discount curve.

The different hedge strategies should allow us to answer these questions. As a little spoiler, the reason
that the single swap hedges are not implemented for two curves is the fact that the results turn out to
confirm the hypotheses that the more refined bucket hedging works better.

Note that the deltas of the assets and liabilities are all calculated to the Euribor curve only, as that is the
regulatory restriction. All statements about deltas to multiple curves only relate only to the swaps, as
these are the collateralized instruments to which the new approach applies. This means that the second
column of table 8, which depicts the total Euribor deltas from the balance sheet, is the basis for all the
hedges. Exposure to the OIS curve can only originate from collateralized swaps designed to hedge the
original exposure of the balance sheet to the Euribor curve.

57
 6.1. Not hedging
It is widely believed that a risk premium is rewarded for taking risk. This leads some entities to the
decision not to hedge, because in the long run the risk premium is supposed to pay out. What the
consequences of such a policy can be for pension fund xyz, is depicted in graph 15:

Graph 15: Unhedged FR fund xyz over the sample period

120%

115%

110%

105%

100%

95%
Unhedged FR
90%

85%

80%
Jul 2007 Jul 2008

The funding ratio drops to 90% and does not reach above the regulatory level of 105% afterwards. This
means that the fund is in serious trouble, with the regulator likely to intervene at the bottom point.
Recall that this is the funding ratio with the equity at a constant level. Given that during the crisis,
worldwide equity dropped over 30%, the fund is likely to have become insolvent.

58
 6.2. Hedging to Euribor only
In this section, the notional of the hedging instruments is determined by deriving the swap deltas to one
curve, so by using equation (20) from the sensitivity section.

Following the approach from section 5.2.2 on bucket hedging, we collect the deltas from the assets and
the inflated deltas from the liabilities and sum these to obtain the balance sheet deltas to all
instruments. These are then divided in buckets and listed in column two of table eight. We then divide
these bucket deltas by their respective instrument per-unit delta. We then obtain the notionals required
to delta hedge all the interest rate risk on the balance sheet.

Table 8: Hedge notional calculation fund xyz

Single curve Euribor Single curve Euribor
Bucket Delta A&L instrument unit delta swap notional
0-2 18,362 -0.000186848 -85,415,526
3-7 272,777 -0.000436473 -598,567,490
8-14 14,316 -0.000781453 -20,794,982
15-25 -345,479 -0.001261082 182,082,291
26-35 -532,402 -0.001556815 167,052,154
36-45 -2,158,585 -0.001744951 1,059,592,126
46+ -922,872 -0.001868351 408,981,098
Total 1,112,929,670
Single 30y
swap -3,653,883 -0.001556815 2,347,024,335

The single swap hedge is obtained here by dividing the summed bucket deltas by the unit delta of the 30
year swap instrument. Because the 30 year swap unit delta is lower than the 40 and 50 year unit deltas,
the resulting notional in the single swap is much higher than the sum of the bucket swap notionals. The
5 year payer swap in the bucket hedge has such a high notional because its unit delta is much lower than
that of the high maturity swaps, which is makes sense given the difference in duration between the
short and long term swaps.

How these hedges will perform in a stress scenario will be analyzed next.

59
 6.2.1. Hedging with Euribor discounted swaps
Before the crisis, it was largely unknown or simply ignored that OIS has to be used for the discounting of
collateralized derivatives. This was not without reason, the Euribor-Eonia spread was nearly zero anyway
so an Euribor-only policy can be argued for at the time. Back then, a hedge was set up to protect the
fund against its exposure to Euribor, and the hedge derivatives were to be discounted with Euribor,
regardless of collateralization. To illustrate how such a hedge would come up in the accounting of the
fund, graph 16 shows how three hedge strategies perform over time. All discounting is done using
Euribor, Eonia does not play any role here.

Graph 16: Euribor discounted hedged FRs

120%

115%

110%

105%
Unhedged FR
100%
Euribor discounted Bucket
95%
hedged FR
90% Euribor discounted single
swap hedged FR
85%

80%
Jul 2007 Jul 2008

Given the adverse scenario hedging is obviously preferred here, as even the simplest hedge keeps the FR
above the regulatory 105% level, while the more refined bucket hedge makes sure that the FR barely
drops at all, separate from the trend described in the cash account section. There is even a small upward
movement at the time that the unhedged and single hedged FRs are at their minimum. This looks like
the effect of an over hedge, but it has a sound explanation. Recall from graph 8 that the 50-40 and 50-30
year spreads are not constant through time. Graph 17 shows some of the instrument swap rates during
the end of 2008:

Graph 17: Swap rates of four Euribor instruments during November-December 2008
5.00%

4.50%

4.00%

3.50%
5y
3.00% 10y
30y
2.50%
50y
2.00%
Nov/2008 Dec/2008

60
The biggest downward movement of the funding ratio is caused by a crash of especially the 40 and 50
year rate,37 the 50-30 year spread in December is much higher than the spread in November .On top of
that, the short term rates do not make the same movement, but stay rather calm compared to the long
term rates, as graph 17 shows. This has the effect that the two receiver swaps with the highest notional,
the 40 and 50 year swap, gain a lot of value, while the 30 year swap gains relatively less. This also
explains the big decrease in the single hedged funding ratio, because the present value of the liabilities
rises sharply due to the lower long term rates while the single swap fails to compensate this effect by
being linked solely to the 30 year rate. This is a prime example of the failed assumption of parallel
movements of the yield curve. Of course, the payer swaps in the bucket hedge have a negative value,
but graph 17 shows that the short rates do not exhibit the huge downward pike that the long rates do.
So the pension fund wins a lot on its receiver swaps while losing much less on its payer swaps.

The falling short rates of course increase the value of the fixed income portfolio, but this is neutralized
by the payer swaps. The total result is that the movements of both the assets and the liabilities are
effectively mirrored by the hedge, greatly reducing the volatility of the funding ratio.

Table 9: FR volatilities with Euribor discounted hedges

Euribor discounted Euribor discounted
Unhedged FR Single swap hedged FR Bucket hedged FR
FR volatility 6.43% 1.63% 0.78%

Table 9 shows the difference in funding ratio volatility between the strategies. We can now draw a
conclusion about the decision whether or not to hedge interest rate risk. If the graph is not clear
enough, table 9 certainly is. For statistical confirmation of these numbers, table 10 depicts the F-values
of the difference in variability of the funding ratio during the sample period between the unhedged FR
and the hedged FRs. The rejection region of the hypothesis that hedging makes no difference is the area
above the F-bound of 1.19.38

Table 10: F-values Hedging vs not hedging

Hedge type Euribor discounted Euribor discounted
Single swap Bucket hedge
Unhedged FR 15.46* 103.14*

The conclusion is unambiguous, hedging makes a huge difference, which is not surprising in a stress
test.39

Remember however, that in this graph the present value of the swaps is calculated using Euribor
discounting, which is deemed inappropriate given the collateralization of all hedge instruments.
Therefore, the next subsection shows the difference between Euribor and Eonia discounting. The latter
is also referred to as CSA discounting, as the reason that this discount rate should be used is the fact

37
The 40 year rate is not shown here to retain overview of the lines in the graph. It behaves like the 50 year rate.
38
It concerns a two sided F-test with 95% confidence level. All samples have 501 data points, being the business
days on which the FR is calculated. We then get
39
Significant F-values will be indicated by an asterisk (*)

61
that the Credit Support Annex specifies that collateral should be used, and of which type. (Here: EUR
cash)

6.2.2. Hedging with OIS discounted swaps

When the exact same derivatives are used with the notionals from table 8, but now discounted with
Eonia, the picture changes. The unhedged case is left out as it is clear that hedging is preferable. This
allows for a change in the y-axis to a 108% minimum, as all hedges keep the funding ratio above this
level. What is shown in graph 18 is are the same hedges as in graph 16 but then zoomed in. The colors
are kept the same; the red line the Euribor discounted bucket hedged FR and the green line being its
single swap hedged counterpart. The two added lines are the exact same hedged funding ratios, but the
swaps are discounted with Eonia instead of Euribor. Recall that the assets and liabilities are still
discounted using the Euribor curve.

Graph 18: Funding ratios with a single hedge or a bucket hedge, discounted with two different curves
120%

118%

116%

114% Euribor discounted Bucket hedge

112% OIS discounted Bucket hedge

Euribor discounted single swap hedge

110%
OIS discounted single swap hedge
108%
Jul/2007 Jul/2008

As the hedges have a positive market value, discounting with the lower OIS curve results in higher value
for the swaps and thus a higher funding ratio. This does not say anything about the quality of the hedge,
only about the impact of using another discount curve. This is confirmed by the statistics in table 11,
indicating that the difference is not only theoretically wrong but also statistically significant.

Table 11: FR volatilities with Euribor and OIS discounted hedges, and the F-values of the differences
Hedge type Euribor discounted Euribor discounted OIS discounted OIS discounted
Single swap Bucket hedge Single swap Bucket hedge
FR volatility 1.63% 0.78% 1.42% 0.63%
Euribor discounting vs OIS discounting F-values
Single swap Bucket
1.32* 1.50*

For both the single swap and bucket hedge case, there is a significant difference in FR volatility due to
different swap valuation. Analysis shows that at the maximum, there is an over 38 million euro

62
difference in valuation of the bucket swap portfolio, about six percent of the total value of the swaps at
that time. This corresponds to almost one percent of assets resulting in a difference in funding ratio of
about one percent. This one percent is clearly visible in graph 18. Note however that this one percent
understates the potential impact of the discounting for separate swaps. The swap portfolio includes
multiple instruments including payer swaps with a negative value, compensating part of the impact. If
the 50 year swap is singled out at the maximum 50 year Euribor zero – 50 year Eonia zero spread, which
is shortly after the Lehmann Brothers bankruptcy event, there is a valuation difference of almost 18% in
using the two different curves for discounting. This illustrates the need for using the appropriate
discount curve.

The next subsection will examine the double curve approach as described in the valuation and sensitivity
sections. This means that the deltas of the swaps are determined to both curves instead of one. The
results will be compared to the best performing single curve hedge; the OIS discounted bucket hedge.

63
 6.3. Using two curves to determine the hedge
For the hedges used in this section, the deltas of the swaps are derived to both the forward curve and
the discount curve, following equations (24) and (25) from the sensitivity section. The OIS discounted
bucket hedge from the previous subsection will be compared with two extensions in an attempt to
improve performance. The first extension considers Euribor par swap deltas that are determined while
taking the separate discount curve into account. The second extension will be treated in the next
subsection, the first extension treated here will be referred to as the two-curve adjusted bucket hedge.

Recall from the sensitivity section that when the delta is derived to the two underlying curves
separately, the instruments have sensitivity to all rates with an equal or lower maturity. For example, in
the single curve case, a 20 year par swap only has sensitivity to the 20 year swap rate. In the two-curve
case, the 20 year swap has exposure mainly to the 20 year rate, but to all the lower maturity rates also.
On top of that, due to the smooth interpolation technique used to build the curve, the 20 year swap also
has sensitivity to the 25 year swap rate, albeit very small. The solution, then, is found by solving a
system of linear equations. This is not shown here, but to illustrate the difference with the single curve
case, the unit deltas are provided in the column next to the single curve unit deltas in table 7. The next
two columns show what the effect is on the notionals of the swaps that are used for hedging. The last
column shows the relative difference in notionals.

Table 12: Hedge notional calculation using two different methods, but both with the goal of hedging the balance sheet deltas
in the second column. The single curve method uses the swap deltas calculated with Euribor as discount curve, the double
curve method takes the separate OIS discount curve into account when calculating the unit deltas of the swaps. The
differences in unit deltas translate into different notionals.
Single curve Two-curve Two-curve
Euribor Euribor Single curve adjusted
instrument instrument Euribor swap Euribor swap
Bucket Delta A&L deltas deltas notionals notionals
0-2 18,362 -0.000186848 -0.000184645 -85,415,526 -82,463,751 96.54%
3-7 272,777 -0.000436473 -0.000433454 -598,567,490 -585,696,797 97.85%
8-14 14,316 -0.000781453 -0.000782364 -20,794,982 -26,702,983 128.41%
15-25 -345,479 -0.001261082 -0.001271362 182,082,291 150,816,258 82.83%
26-35 -532,402 -0.001556815 -0.001567551 167,052,154 161,037,837 96.40%
36-45 -2,158,585 -0.001744951 -0.001709394 1,059,592,126 1,065,815,297 100.59%
46+ -922,872 -0.001868351 -0.001709394 408,981,098 440,012,485 107.59%
Total 1,112,929,670 1,122,818,346 100.89%
Single (30y) (30y)
swap -3,653,883 -0.001556815 -0.001567551 2,347,024,335 2,330,950,740 99.32%

The last column is actually the most important one, it tells how big the difference in notional of the
hedging instruments is. What will be done now is check whether these differences in hedge notionals
deliver a better hedge over the sample period.

64
The effect of this adjustment is shown in graph 18. Note that we tightened the y-axis of the graph again,
because no OIS-discounted bucket hedge falls below 110% during the sample period. We have taken the
best strategy from graph 18, being the single-curve OIS discounted bucket hedge, and compared this
with the two-curve adjusted bucket hedge.

Graph 19: FR with single-curve based hedge vs FR with double-curve based hedge
117%

116%

115%

114%

113%

112%
Adjusted bucket hedge FR
111%
OIS discounted Bucket hedge
110%
Jul 2007 Jul 2008

The adjusted hedge seems to do better when the interest rate shocks get large at the end of 2008,
mostly due to the higher notional in the 50 year swap. Note however, that even though the separate,
discount curve is taken into account when calculating the swap deltas, the OIS deltas have been left
open. The next section hedges this residual exposure with Eonia swaps and analyzes the performance.

65
 6.3.1. Double curve hedging
Now, the first extension is extended even further by adding OI swaps in order to take away the Eonia
exposure. This means that we take the two-curve adjusted bucket hedge from the previous subsection
and attempt to take away the OIS exposure resulting from the collateralized Euribor swaps. This
extension will be referred to as the double curve hedge; which it is as it hedges the deltas to both
relevant curves.

The assets and liabilities are still discounted using the Euribor curve and do not have any Eonia
exposure. Table 13 then shows the Eonia deltas resulting from the initial Euribor hedge and how this
translates into OI swap notionals.

Table 13: OIS hedge notional calculation. The Euribor swaps have exposure to the OIS curve which has to hedged with OI
swaps. The highest two buckets are empty because the highest OI swap being traded is the 30 year instrument, so the OI
deltas from the 40 and 50 year Euribor swaps are added to the 26-35 year bucket.
Two-curve Euribor Two-curve OI swap
Bucket swap notionals Two-curve Eonia deltas OI swap unit deltas notionals
0-2 -94,187,156 -81 -0.000187302 432,161
3-7 -606,616,125 -188 -0.000438118 430,027
8-14 -25,123,427 19,505 -0.000785742 -24,823,549
15-25 235,099,683 65,804 -0.001273287 -51,680,504
26-35 334,740,268 -153,436 -0.001575864 97,366,380
36-45 1,243,822,280
45+ 531,423,471

Note that all the OI exposure of the highest three buckets is gathered in the 26 to 35 year bucket,
because the 30 year OI swap was the highest traded during the sample period. Also recall that the
addition of Eonia swaps is difficult to achieve for high notionals due to lack of liquidity. The notional of
almost a 100 million in the 30 year OI swap is unlikely to be easily tradable. For the sake of curiosity
whether this extension is useful, we continue as if the trade can be executed without problems. When
the Eonia bucket hedge from table 13 is added to the existing hedge, graph 20 results:

Graph 20: Double curve hedge vs two-curve adjusted hedge

117%

116%

115%

114%

113%
Adjusted bucket hedge FR
112%
Doublehedged FR
111%

110%
Jul 2007 Jul 2008

66
Again, the more complicated hedge performs slightly better in terms of keeping the FR from falling.

Even though this hedge may not be executable in practice at this time, possibly in the future it will be.
Table 14 shows that it may be worthwhile, as the double curve hedge performs significantly better than
the normal OIS discounted bucket hedge.

Table 14: FR volatilities under different hedge strategies, and the resulting F-statistics of the differences in variance.
Hedge type OIS Discounted Bucket OIS Discounted two-curve Double curve
hedge adjusted hedge hedge
FR volatility 0.63% 0.60% 0.57%
OIS discounted bucket OIS Discounted two-curve
hedge adjusted hedge double curve
OIS discounted
bucket hedge 1
OIS Discounted two-
curve adjusted hedge 1.11 1

double curve 1.24* 1.12 1

The adjusted notionals, however, do not by itself make a significant difference. Also, the addition of OI
swaps over the adjusted hedge does not have a significant effect. Taking into account that liquidity
constraints will make it more expensive (if even possible) to obtain the high maturity OI swaps discards
this method as fruitful at this time. Also keep in mind that the F-bound should possibly be somewhat
higher than 1.19 to correct for autocorrelation, further reducing the feasibility of this strategy.

67
 6.4. Upswing scenario
As a back test for the hedge quality, an opposite scenario is also analyzed. A large increase in the
interest rates is used to test robustness of the results. The scenario chosen is reversed to the original
one, while the initial curves are equal to that of the downward scenario. This means that the hedges,
which are based on the curves at the start date, are the same as before. Graph 21 shows the six month
rates for both curves, to indicate the scenario that the hedges have to cope with.

Graph 21: Simulated 6m Euribor and 6m Eonia over the sample period
10.00%
9.00%
8.00%
7.00%
6.00%
5.00%
4.00%
3.00%
6m Euribor (simulated)
2.00%
6m Eonia (simulated)
1.00%
0.00%
Jul/2007 Jul/2008

This scenario is usually not bad for a pension fund, since the value of the liabilities will go down in this
scenario. As we are using linear products to hedge, the effect of all hedge strategies should be the
opposite compared with the original scenario. Funding ratio volatility is still the most important
determinant, but it is also analyzed how much ‘damage’ the hedge does in this circumstance. We will
show a summarized report below. Since we have already established the right way to discount, only the
OIS discounted hedges will be shown.

6.4.1. Upswing scenario analysis

Graph 22 shows the obvious conclusion that not hedging is best here, given the interest rate upswing. It
is clear that the volatility of the FR averaged over the two scenarios is very high if no hedge is put in
place. The hedged FRs barely deviate from their path in the other scenario in graph 17. In other words,
volatility over the two extreme scenarios is low, while the unhedged FR again shows large peeks and
bumps. Note that the downward trend of the funding ratios40 is greater than in the downward interest
rate scenario. This makes sense; the equity is still constant while the discounting effect has a larger
impact on the present values of the liabilities and the fixed income portfolio when interest rates are
higher. This is the problem discussed in section 5.2.5, but has no consequences for the conclusion that
the bucket hedge performs best.

40
The unhedged scenario inherits the same trend, but this is not visible due to its high volatility.

68
Graph 22: Unhedged vs hedged FR in simulated scenario
140%
Unhedged FR
135% OIS discounted Bucket hedge

130% OIS discounted single swap hedge

125%

120%

115%

110%

105%
Jul 2007 Jul 2008

Again, the bucket hedge outperforms the single hedge, confirming that the curve does make non-
parallel movements and that this can be accounted for with a bucket hedge. Of course, there are
scenarios where the 30 year rate would move much more than the other rates so that the single swap
hedged FR would do better, but that does not disregard the conclusion about the volatility in table 15.
The bucket hedge still outperforms its simpler opponent with a significant difference.

Table 15: Upswing FR volatilities

Hedge type OIS discounted OIS discounted
Single swap hedge Bucket hedge
FR volatility 1.42% 0.63%
Single swap hedge vs Bucket hedge, both OIS discounted
F-value 1.49*

The more complicated strategies are not shown here, because the variances barely deviate from the OIS
discounted bucket hedge strategy. The adjusted notionals and the addition of OI swaps slightly harms in
this case in the sense that the market value of the swap portfolio is even more negative than for the OIS
discounted bucket hedge. This results in a somewhat higher FR volatility. Another test with inverted
initial curves yielded differences so small that the variances ratios approach one and are thus far from
significant. This does not discard the performance in the downward scenario, but does question the use
of a much more complicated strategy which adds very little performance, if any. We can conclude that
the bucket hedge holds up as outperforming the single swap hedges while the more complicated
strategies do not conclusively stand with performance different from a single curve OIS discounted
bucket hedge.

69
7. Conclusion
7.1. What is the impact of collateralization on swap curves and their users?
Derivative contracts are increasingly being collateralized to prevent shifting market risk to credit risk
when hedging financial risks using derivatives. This has impact on the valuation of these now riskless
contracts because the discount rate of the embedded future cash flows is no longer extracted from the
swap curve but is determined by the growth rate of the underlying collateral specified in the CSA. For
cash and high-quality bond collateral the discount rate can be extracted from the OIS curve which is
more appropriate for the risk profile of collateralized cash flows. This has the consequence that swap
instruments are no longer viewed as the single determinant of the swap market, because market wide
collateralization has forced the Euribor swap markets’ discounting to be dependent on another class of
instruments which no longer behaves on a predictable spread. The swap curve that is left now has
different dynamics than before and should therefore be interpreted accordingly by its users, being
effectively the whole financial sector and treasury departments. This thesis attempts to hand them the
tools required for the current reality in this field.

The change in swap markets extends to the discounting of all future cash flows because swaps are the
main instruments for building zero curves used for discounting. The impact of collateralization of swap
contracts combined with an increased Euribor-OIS spread is therefore a market wide shift to a multiple
curve framework. Secured cash flows should be discounted with the OIS curve while the swap curve is
still the base for unsecured discounting but with different dynamics than before.

Not only is it theoretically the right method to discount collateralized derivatives with the overnight
interest rate curve, it has now also empirically been established that wrong discounting can have
negative consequences on the hedge effectiveness. After deriving the deltas to two separate curves, the
impact is quantified for the case of a pension fund. It turns out that the valuation difference due to using
OIS discounting of the hedge instruments can be as much as one full percent of the reported funding
ratio. Given that these funds as well as insurance companies are regulated on this measure of solvency,
the need for proper accounting cannot be understated.

As for the different hedging strategies, bucket hedging clearly outperforms a single swap hedge by
weakening the unrealistic assumption of parallel yield curve movements and successfully acting
according to this new situation. The more complicated approaches using two curve deltas look
promising from a theoretic viewpoint, but require more research and feasibility in the sense of liquid OIS
markets. If these are to develop, the hedge efficiency could be improved with the help of new
instruments such as Euribor-Eonia basis swaps. This is left to the future.

70
 7.2. Limitations & extensions
Some assumptions made tighten the generalizability of the methodology but not of the results.
Assuming a tight CSA which only allows for Euro cash collateral seems very strict, but in the case of bond
collateral the repo rate is often not far from the OIS rate, as noted in section 2.4.1. Also, specifying the
Euro as only currency was necessary to prevent optionality from entering the swap valuation, but as
discussed in the section on CSA optionality, this is a market wide problem. The results are expected to
hold under other currencies, but the methodology will have to be adjusted to account for other leg
maturities which are the standard in the USD and GBP market. These changes are mere technicalities,
however.

A real limitation is the assumption that the forward curves can simply be derived from the Euribor curve,
which is not as simple in the real, collateralized world. In this world, formula (2) will not hold, and the
forward curve should be derived as in section 3.3, or from other products such as FRAs. Applying this
would greatly increase complexity while it is not expected to distort the results. For research on forward
curves, the reader should follow Mercurcio (2009), whereas this thesis has focused on the discount
curves.

One could argue that assuming a closed pension fund is a limitation, but consider then that there are
many such funds in the world. Of course, extending this work to an open fund is possible, but then an
assumption like constant in and outflow of participants and cash flows is probably required. Fact is that
a one-size-fits-all approach is not optimal; every fund should be analyzed first before hedging. There are,
however, general principles that should be applied and that is exactly what this thesis is trying to show.

Making the equity a fixed number over the whole sample period is of course not realistic, but the goal
was to minimize the impact unrelated factors on the FR volatility. Since adding a constant to every value
in a time series does not change the variance of the time series, this seemed the best way to prevent
noise from equity movements. Of course, the absolute funding ratios at the midst of the crisis would be
lower if the equity was booked against market value. However, this would completely distort the
interest rate effects we are trying to extract. The results should therefore not be looked at in the sense
of absolute FR declines, but purely comparing different strategies under the same circumstances. I
believe that has been achieved.

Even though outside distortions have been minimized, the sample is not entirely free of bias. Given that
interest rates are the basis for the results, the fact that they are not free of serial correlation puts
pressure on the reported F-values. Of course, some reported variance ratios leave little doubt, but the F-
bounds are probably wider than is reported. This should be taken into account when judging feasibility.
For the future, these problems could be taken away in an ALM analysis, where the interest rates are the
independent variable. Averaging over 1000 scenarios should solve the problem and provide more insight
in hedge behavior over different curves. This has not been performed here because the focus has been
on stress testing, not on ALM.

71
72
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9. Appendix
Table 16: Bloomberg codes of data used. Data used from 1-7-2007 to 30-6-2009
Maturity Euribor EONIA
1d41 EONIA Index
6m EUR006M Index EUSWEF Curncy
1y EUSA1 Index EUSWE1 Curncy
2y EUSA2 Curncy EUSWE2 Curncy
3y EUSA3 Curncy EUSWE3 Curncy
4y EUSA4 Curncy EUSWE4 Curncy
5y EUSA5 Curncy EUSWE5 Curncy
6y EUSA6 Curncy EUSWE6 Curncy
7y EUSA7 Curncy EUSWE7 Curncy
8y EUSA8 Curncy EUSWE8 Curncy
9y EUSA9 Curncy EUSWE9 Curncy
10y EUSA10 Curncy EUSWE10 Curncy
11y EUSA11 Curncy EUSWE11 Curncy
12y EUSA12 Curncy EUSWE12 Curncy
15y EUSA15 Curncy EUSWE15 Curncy
20y EUSA20 Curncy EUSWE20 Curncy
25y EUSA25 Curncy EUSWE25 Curncy
30y EUSA30 Curncy EUSWE30 Curncy
35y EUSA35 Curncy
40y EUSA40 Curncy
50y EUSA50 Curncy

41
Not used to build a curve, only for calculating daily cash account accrual.

75
 50y 40y 35y 30y 25y 20y 15y 12y 11y 10y 9y 8y 7y 6y 5y 4y 3y 2y 1y 6m

0.798 0.801 0.799 0.800 0.814 0.846 0.890 0.910 0.915 0.918 0.920 0.921 0.923 0.928 0.934 0.941 0.948 0.958 0.982 1.000 6m

0.864 0.869 0.868 0.871 0.883 0.909 0.939 0.954 0.957 0.960 0.962 0.964 0.966 0.970 0.975 0.981 0.986 0.993 1.000 1y

0.881 0.886 0.887 0.891 0.904 0.930 0.958 0.971 0.975 0.978 0.980 0.982 0.985 0.988 0.992 0.995 0.998 1.000 2y

0.884 0.890 0.891 0.895 0.909 0.937 0.966 0.979 0.982 0.985 0.988 0.990 0.992 0.995 0.997 0.999 1.000 3y

0.887 0.893 0.894 0.899 0.914 0.942 0.971 0.983 0.987 0.990 0.992 0.994 0.996 0.998 0.999 1.000 4y

0.892 0.899 0.901 0.906 0.920 0.948 0.976 0.988 0.991 0.993 0.995 0.997 0.998 0.999 1.000 5y

0.899 0.905 0.907 0.913 0.927 0.954 0.981 0.991 0.994 0.996 0.997 0.999 1.000 1.000 6y

0.905 0.912 0.914 0.919 0.933 0.960 0.985 0.994 0.996 0.998 0.999 1.000 1.000 7y

0.909 0.915 0.918 0.923 0.937 0.963 0.987 0.996 0.997 0.999 1.000 1.000 8y

0.913 0.920 0.922 0.928 0.941 0.967 0.990 0.997 0.999 1.000 1.000 9y
Table 17: Correlation matrix Euribor instruments over sample period

0.918 0.924 0.926 0.932 0.945 0.970 0.992 0.998 0.999 1.000 10y

0.923 0.929 0.931 0.937 0.950 0.974 0.995 1.000 1.000 11y

0.928 0.934 0.936 0.942 0.955 0.979 0.997 1.000 12y

0.947 0.953 0.955 0.960 0.972 0.990 1.000 15y

0.978 0.982 0.984 0.988 0.994 1.000 20y

0.993 0.996 0.997 0.999 1.000 25y

0.997 0.999 1.000 1.000 30y

0.999 1.000 1.000 35y

0.999 1.000 40y

1.000 50y

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77