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Will Central Clearing remove the Convexity Adjustment between the Forward Rate and the Futures Rate?

Posted: November 16th, 2012, 3:25 pm
by PvalAnal85
Hello,As I understand it, the reason that convexity basis exists between a LIBOR forward contract and a LIBOR futures contract is the mandatory margin deposit/withdrawal with the futures exchange whenever the MTM of the future moves out/in your favour. This need for daily margin comes at a drag on cost, so the futures rate is higher than the forward rate to compensate the investor for this cost (as forwards contracts are largely bilateral).However, given that derivatives (including forwards contracts) are going to be centrally cleared through CCPs as a result of Dodd-Frank legislation, and this means that forwards are also going to have IM & VM requirements, will this make the convexity between forwards and futures contracts disappear? Thanks

Will Central Clearing remove the Convexity Adjustment between the Forward Rate and the Futures Rate?

Posted: November 17th, 2012, 9:16 am
by ppauper
how did you get that nickname, Pval ?

Will Central Clearing remove the Convexity Adjustment between the Forward Rate and the Futures Rate?

Posted: November 17th, 2012, 10:28 am
by gjk77
When interest rate swap are cleared, you are compensated for funding the VM, the so-called "price alignment interest" which means there will not be the convexity correction you are thinking of, and the swap is economically equivalent. However, this PAI is only for OTC products, the futures contracts do not have this and so the convexity correction remains for them. There is an interesting recent case with Jefferies and IDCG where this was not well understood, search for "jefferies idcg lawsuit". To add a twist to this, CME has a new swap future contract, that will have a convexity correction as it is designed like existing futures, yet the underlying is a cleared swap.

Will Central Clearing remove the Convexity Adjustment between the Forward Rate and the Futures Rate?

Posted: November 17th, 2012, 5:49 pm
by tagoma
QuoteOriginally posted by: ppauperhow did you get that nickname, Pval ?sometimes one stands close to success. but, he/she finally fails for stupid reasons.

Will Central Clearing remove the Convexity Adjustment between the Forward Rate and the Futures Rate?

Posted: November 19th, 2012, 6:41 pm
by PvalAnal85
@gjk77- thanks very much. I'll take a look at the Jeffries case you referred to.@ppauper- if you must know, PvalAnal stands for "Portfolio Valuation Analyst" (my old job title).

Will Central Clearing remove the Convexity Adjustment between the Forward Rate and the Futures Rate?

Posted: November 20th, 2012, 10:05 am
by katastrofa
Did you work in Markit Group, Pval?

Will Central Clearing remove the Convexity Adjustment between the Forward Rate and the Futures Rate?

Posted: November 20th, 2012, 1:48 pm
by mathmarc
QuoteOriginally posted by: PvalAnal85 [...] given that derivatives [...] are going to be centrally cleared [...] will this make the convexity between forwards and futures contracts disappear?By opposition to some other posts, I think this is not a stupid question. The answer is: it depends! It is a generic answer to a generic question. It depends of the clearing mechanism. If an interest rate equal to the risk free rate is paid on the margin (like OIS, subject to OIS being risk-free), then the same valuation mechanism can be used for (credit) risk free derivatives and collateralised/cleared derivatives (this is essentially Piterbarg, Risk 2010, result).If the rate paid on the margin is 0 (and this has been proposed at some stage by some market participants, in particular for a review of the ISDA CSA), then the convexity adjustment between 0 rate-margined OTC and futures disappears. This is discussed in my recent paper: Multi-Curves: Variations on a Theme, OpenGamma Quantitative Research 6.

Will Central Clearing remove the Convexity Adjustment between the Forward Rate and the Futures Rate?

Posted: November 20th, 2012, 3:56 pm
by PvalAnal85
Thanks Marc! In the middle of your paper now- it makes interesting reading.

Will Central Clearing remove the Convexity Adjustment between the Forward Rate and the Futures Rate?

Posted: November 28th, 2012, 5:05 pm
by PvalAnal85
In relation to the Jeffries vs. IDCG case, there's recent news of ICE converting all their cleared energy swaps into "economically equivalent" futures.Are they 'economically equivalent'? (IDCG''s weren't!) And even if they're not, does the act of converting ALL swaps into futures remove the potential for any arbitrage?