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Hymn
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Joined: February 27th, 2012, 1:52 pm

How to select the IR curve to discount cash flows?

April 15th, 2020, 2:34 pm

Hi,
I want to define a fixed rule to select a correct IR curve (ex from Bloomberg) to discount cash flows. I am interesting only in the interest rate curve and not also in market spread.
For example, in your experience, if you have to discounts a quarterly cash flows what kind of IR curve do you use? The EUR vs Euribor 3M (BBG ID 201)? And what else, if the cash flows are semi-annual?
Could you suggest me some papers/books about this subject?
Many thanks in advance.
 
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SWilson
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Joined: February 13th, 2018, 5:27 pm

Re: How to select the IR curve to discount cash flows?

April 20th, 2020, 7:28 pm

Without getting into too much detail, search for OIS discounting framework.  That seems to be the most generally accepted method for now.  I'm assuming you're discounting cash flows from a financial instrument.  If you're discounting an enterprise cash flow then there are other more generally accepted methods.  
 
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Hymn
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Joined: February 27th, 2012, 1:52 pm

Re: How to select the IR curve to discount cash flows?

April 21st, 2020, 9:31 am

Yes, I need to discount cash flows from a financial instruments not collateralized.
 
 
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fyvr
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Joined: November 15th, 2015, 3:10 pm

Re: How to select the IR curve to discount cash flows?

May 2nd, 2020, 1:51 pm

This is a subtle issue, but here goes with the bare bones.

You should be able to convince yourself that the correct rate to discount future cashflows, in generality, is your effective cost of funding. But what is this?
1) for perfectly collateralised trades, it is a fact (not especially obvious at first glance, I concede) that on an expectation value basis all cash required or generated for a position is supplied/absorbed by the transfer of collateral. So your effective cost of funding is whatever rate on posted collateral is specified in the CSA, which is usually (approximately) OIS. So that's the curve you want.
2) for uncollateralised positions, you have a choice.
(a) you can say sod it, our systems are set up to PV along OIS curves, so we will stick with that even though we know it's wrong... and then manually adjust for the wrongness with XVA adjustments.
(b) you could try and build a correct zero curve... if you think 3M Euribor is a decent approximation to your desk's cost of funding (frankly, I doubt it), you can use that [it has the advantage of being a very convenient fiction, which is why it was market standard until about 2009]; or if you're feeling brave you could try and build your own bespoke funding curve.
Most people vote for (a), or a variation of it ('CSA discounting'). But it does lead you into the murky depths of XVA, so it's by no means an easy option.
 
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Hymn
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Joined: February 27th, 2012, 1:52 pm

Re: How to select the IR curve to discount cash flows?

May 4th, 2020, 6:05 am

Thanks.
I think that for me is more convenient the option 2b, I can try to use the funding curve used by treasury function. Anyway, I will add a spread over the curve to capture the market/credit risk.