When it comes to investing in financial instruments, valuation is not just critical to determining a vehicle's fair market value, but it is also essential for financial reporting and risk analysis functions. The most common valuation tool, known as the discounted cash flow (DCF) method, is used to project future cash flows, while simultaneously highlighting the likely discount rates attached to those cash flows.

Key Takeaways

  • When contemplating an investment opportunity, research analysts rely on the discounted cash flow method as a valuable tool with which to estimate cash flows.
  • The value of derivative instruments presumes that all of an investment's underlying assets are based on the risk-free rate; therefore, the real growth rate of those assets does not impact projected values.
  • Collateralized derivatives are considered to be less risky, because such transactions pose less counterparty risk, given that the collateral can be used to counter any losses.
  • Collateralized derivatives are much safer investments than their non-collateralized counterparts, and they are consequently valued with risk-free rates.

Derivative Valuations Before and After the 2008 Economic Crisis

Financial derivatives introduce diversification to an investment portfolio by facilitating exposure to different markets. The value of these derivatives assumes that the returns on all underlying assets are based on the risk-free rate. Therefore, the real rate at which those underlying assets grow does not materially affect their values. This concept is known as “risk-neutral” valuation.

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

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

Such counterparty risk famously led to the bankruptcy of investment banking giant Lehman Brothers. As the counterparty to 930,000 derivative transactions, representing approximately 5% of global derivative activity, the bank was unable to crawl out from under its crushing $619 billion debt, and ultimately shuttered its doors for good.

Collateralized Versus Uncollateralized Derivatives

Derivatives that trade over-the-counter (OTC) employ standard ISDA agreements that frequently include Credit Support Annex (CSAs), which are clauses that outline permissible credit mitigants for a transaction, such as netting and collateralization. Collateralized transactions pose less counterparty risk because the collateral can be used to recoup any losses. When such collateral falls below a certain threshold, more can be sourced.

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

OIS Discounting and Risk-Free Rates for Collateralized Derivatives

Standard CSA agreements limit losses by mandating daily collateral calls in order to prevent counterparties from closing out. Amid this backdrop, the natural choice for the risk-free discount rate is typically some type of overnight rate. This is referred to as "OIS discounting" or "CSA discounting." Overnight yield curves can be derived from overnight index swaps (OIS).

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

Historical Spread between 3-month USD LIBOR and the Fed Funds Effective overnight rate (Data source: www.treasury.gov and www.research.stlouisfed.org)

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

Daily collateral calls suggest that OIS discounting is the logical choice for such types of valuation.

The Bottom Line

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

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