Valuation Risk for Derivatives - Birol Unal

Yeah, so let me just tell some of the, I guess, really, really interesting just valuation risk issues that arose over time.

And I guess...

I mean, it just happens.

I mean, it really just arises in one day and you realize you've got a just big valuation issue.

industry swaps they sound really just as straightforward as simple i think at around 2007 and people were still trading a tenor swaps the floating leg of industry swap can be just on a three-month libor or six-month libor there's a different tennis uh of the of the rate uh and then We used to just assume, just the models in the banks, they used to assume that a six-month LIBOR rate can be replicated from a three-month LIBOR spot and a in three months for three months of fraud.

That's the forward rate.

And just using the classical textbook arbitrage arguments is very straightforward.

And that's how we used to just value just tenor swaps.

And so if you have a three-month versus six-month tenor swap for whatever reason in your book, we just used to say, yeah, so it doesn't have, it has always a zero value.

That's what

So the 3-6 basis is basically zero.

Zero, exactly.

Okay, yeah, indeed,

right.

That's just a classical case of actually a model not really incorporating.

So you

take something out of your corporate finance or your financial economics textbook, plug it in, and of course that says your 3-6 basis has to be zero.

Market, generally speaking, has a different idea.

Yes, okay, so tell us what happened.

And the market just became just more, I guess, sophisticated and Especially the traders who trade these products, they realize actually, hmm, I can't really arbitrage a six-month LIBOR rate by trading three-month and three-month.

And then they started just building this basis when they were trading in the interbank market.

And then just one day you realize actually there's an interbank broker page which says, ah, if you're trading a three-month versus six-month LIBOR swap, there's a basis.

absolutely on

that day exactly so on that day uh it is it is really it's a good example yeah so good example of valuation risk in the sense that um i've got a model it has an import i mean everyone will worry about yeah so what the value of that input should be yeah so it's normal yeah so how can i drive the value of this input but if your model doesn't have that input yeah so No, absolutely.

Don't worry about that input.

Yeah, so let me just tell some of the, I guess, really, really interesting just valuation risk issues that arose over time.

And I guess...

I mean, it just happens.

I mean, it really just arises in one day and you realize you've got a just big valuation issue.

industry swaps they sound really just as straightforward as simple i think at around 2007 and people were still trading a tenor swaps the floating leg of industry swap can be just on a three-month libor or six-month libor there's a different tennis uh of the of the rate uh and then We used to just assume, just the models in the banks, they used to assume that a six-month LIBOR rate can be replicated from a three-month LIBOR spot and a in three months for three months of fraud.

That's the forward rate.

And just using the classical textbook arbitrage arguments is very straightforward.

And that's how we used to just value just tenor swaps.

And so if you have a three-month versus six-month tenor swap for whatever reason in your book, we just used to say, yeah, so it doesn't have, it has always a zero value.

That's what

So the 3-6 basis is basically zero.

Zero, exactly.

Okay, yeah, indeed,

right.

That's just a classical case of actually a model not really incorporating.

So you

take something out of your corporate finance or your financial economics textbook, plug it in, and of course that says your 3-6 basis has to be zero.

Market, generally speaking, has a different idea.

Yes, okay, so tell us what happened.

And the market just became just more, I guess, sophisticated and Especially the traders who trade these products, they realize actually, hmm, I can't really arbitrage a six-month LIBOR rate by trading three-month and three-month.

And then they started just building this basis when they were trading in the interbank market.

And then just one day you realize actually there's an interbank broker page which says, ah, if you're trading a three-month versus six-month LIBOR swap, there's a basis.

absolutely on

that day exactly so on that day uh it is it is really it's a good example yeah so good example of valuation risk in the sense that um i've got a model it has an import i mean everyone will worry about yeah so what the value of that input should be yeah so it's normal yeah so how can i drive the value of this input but if your model doesn't have that input yeah so No, absolutely.

Don't worry about that input.