A guide to money market function
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A guide to money market function

Archive Manager by WEB DESK
Dec 3, 2012, 12:00 am IST
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Jayant Patel
Discounting, LIBOR, CVA and Funding: Interest Rate and Credit Pricing
, Chris Kenyon and Roland Stamm, Palgrave Macmillan, Pp 256, £ 39.99

Interest is the price that one pays for borrowing money and usually depends on the maturity of the loan as well as the creditworthiness of the borrower. The latter is influenced by the borrower’s (projected) liquidity situation and available assets.

An important market in the financial world is the money market where banks lend each other or borrow money from the central bank. Maturities in the money market are typically up to one year. The rate at which the banks enter into a loan are individual basis, there is the concept of an average rate which is fixed once on a daily basis. This inter-bank offer rate is called EURIBOR in the EUR market and LIBOR for all currencies that are traded in the money market in London.

This thoroughly technical book requires a good basic knowledge of mathematics, especially of differential equations. As this reviewer is no mathematician or anywhere near it, a brief outline is presented of the book.

The book is a reminder of the basic terminology and details of the interest rate markets, as well as the “old school” approach of pricing simple interest rate products.

It explains how to build a zero/discount curve from market data. After an introduction to credit investments and associated terminology,  the book  presents the most relevant definitions of credit spreads and the instruments associated with them, their market risks and the connections between them.

Leaving the credit spreads behind, Chapter 4 introduces the problems with the old way of pricing that arose with the credit crisis in 2008.The basis spread, formerly almost irrelevant phenomena in the interest rate markets, became a new source of market risk as well a pricing complexity.

Their impact on curve building and pricing is investigated in Chapter 5 which describes what happens in a one-currency world.

The book discusses what needs to be done for non-linear products, that is, products that contain optional components.  It gives an overview of the current state of research in this area. It also presents evidence that the common view of debit value adjustment giving rise to profits, if one’s own credit quality deteriorates, is false when the bank’s balance sheet as a whole is considered. Firm-level effects may appear to be only paper or accounting realities with real effects. If the balance sheet says that your equity is below its regulatory threshold, then there are firm-level consequences. Furthermore, regulators decided to introduce credit value adjustment volatility capital charge as a direct consequence of such losses in the 2008 financial crisis. The fact that trading realities are not accounting realities creates tensions for trading checks.

 The book lays emphasis not on “funding, funding, funding”, but “capital capital, capital” and brings in a host of innovations, the first of which to hit significantly is the capital charge for credit value adjustment volatility.

A chapter is on back testing of risk factor equations (RFEs) and says that capital charges for trading desks can be calculated from counter-party exposure profiles per legally enforceable netting set.

The book is a valuable read for subject-specific readers.

(Palgrave Macmillan, Basingstoke, Hampshire, RG21 6XS; www.palgrave.com)

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