In the extension of the previous post, I’ll cover a bit the funding curves: what it means and how they’re being used.
- What are the funding curves?
A funding curve crystallizes the funding spreads over the market rates for the bank. Usually you will find that these spreads are over the O/N rate and the funding curve is often in USD.
That curve represents the cost to the bank to fund their positions. When it needs to be expressed in different currencies the current approach is to ratio discount factors: Df(XXX funding curve)/Df(USD funding curve)=Df(XXX/USD basis curve)/Df(USD OIS curve). The assumption behind is that swap points are a constant. So you end up with the discount factor you’re after (Df(XXX funding curve) as Df(XXX/USD basis curve)*Df(USD funding curve)/Df(USD OIS curve).
2. How to set them up?
In Murex, this can be setup using the Automatic CSA curve setting. You’ll need to define a CSA category (such as No collateral) and attach the proper curve assignment to USD (assuming you’re using USD for funding).
3. When are they used?
Trades can be collateralized or not. To be collateralized, they need to be covered by an agreement with your counterpart and in that case, any large market value for that transaction will trigger a margin call and thus limit the risk for both sides.
When the trades are not collateralized, this is when you want to use the funding curves as the bank is much more exposed and the returns expected are higher.
In terms of pricing, this also means that when trading with a non collateralized counterparty, the prices will be worse given the increased rates.
4. Anything else? Risk management maybe?
This is where the funding desk comes into the picture. The role of that desk is to determine the funding spreads but also to manage the risk coming from these curves. For traders, they will also look at their portfolios as if all trades were fully collateralized BUT any trade with a counterparty with no agreement will effectively use the funding desk as an intermediary : the funding desk trades the same trade back to back, with the counterpart using the funding curves and with the trading desk using normal curves (OIS or basis curves).
In a nutshell, that’s what funding curves are about. As always, questions or comments are more than welcome!