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  • Writer's pictureWilliam Webster

Financial Product Valuation: Part Two-Discounting

In our exploration of financial valuation methodologies, we delve into the second part of our series, focusing on the discounted cash flow (DCF) method. This approach is particularly relevant for derivatives like swaps, which have known future cash flows. These cash flows can be discounted back to their present value, a process integral to understanding the current worth of these financial instruments.

The Core Concept of Discounting Cash Flows

Discounting cash flows is a cornerstone of financial valuation. It involves calculating the present value of expected future cash flows using discount factors derived from an appropriate yield curve. This technique is widely used for valuing derivatives with predictable future cash flows, such as swaps.

Methodologies and Discount Factors

There are various methodologies for deriving discount factors, primarily based on zero-coupon techniques. These techniques help eliminate the reinvestment uncertainty associated with yield curves derived from par-based interest rates. While these models can be built using spreadsheets, modern financial institutions often utilize sophisticated risk management systems that streamline these valuations.

Practical Application in Swap Valuation

When valuing swaps, a swap yield curve is used to derive discount factors. These factors discount the swap's future cash flows to their present value. This is done for both the fixed and floating sides of the swap, resulting in a net present value. Even though future floating rates are not yet determined, this issue is resolved by calculating the implied forward rates from the yield curve.

Implications of Net Present Value

A positive net present value indicates that the derivative is "in the money," representing an unrealized profit. Conversely, a negative valuation suggests an "out of the money" position, indicating an unrealized loss. This understanding is crucial, especially if the derivative is used for hedging purposes. The profit or loss from the derivative should ideally offset the change in value of the hedged item. Any deviation from this indicates hedge slippage.

Accounting and Liquidity Implications

Valuation changes in derivatives are reflected in the profit and loss account, impacting the financial institution's liquidity position. Moreover, these valuations, often done daily or even more frequently, are crucial for collateral management with swap counterparties. A positive mark-to-market on a swap indicates a credit risk on the counterparty, emphasizing the importance of collateral agreements.

Why Discount Cash Flows for Swaps?

Discounting cash flows is a pragmatic approach for valuing swaps, as individual traded prices are not readily observable post-initiation. As swaps accrue interest on both sides, and their remaining maturity changes over time, direct market price comparison becomes impractical. Instead, discounting the accruing cash flows provides a more accurate valuation.

Extending the Methodology to Other Instruments

While the DCF method is straightforward for instruments like swaps, it can also be applied to other financial products with known future cash flows, like bonds. However, caution is advised. Different financial instruments trade on different yield curves and have varying liquidity qualities. Ignoring these factors can lead to inaccurate valuations.

A Cautionary Note on Yield Curves and Market Prices

Using an inappropriate yield curve, such as discounting a low-quality bond's cash flows with a swap yield curve, can falsely inflate the bond's value. This error arises from ignoring the credit and liquidity differential between the two markets. Therefore, selecting the correct yield curve is vital for accurate valuation.

Summary and Considerations

In summary, discounting cash flows is a simple yet effective approach widely used in financial institutions. It applies to various financial instruments, from simple derivatives to bonds, provided that credit and liquidity adjustments are appropriately made. A final consideration is whether valuations are based on bid, offer, or mid-market prices, especially when considering the liquidity cost of exiting a position early.

A third article will explore valuations using models.

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