Derivatives Pricing Architecture

Client

Major European Investment Bank

Keywords

•    Derivatives Valuation
•    Financial Instruments Pricing architecture

Context

For the production of daily analytics of its derivatives portfolio, the client was considering building an independent and properly documented in-house pricing platform for the valuation of derivatives, the construction of yield curves and the production of various relevant risk sensitivities.
The Derivatives Valuation Unit within the Risk Management department at the client performs derivatives pricing through a third-party library. To remediate difficulties and shortcomings to this setup, and boosted by the acquisition of in-house derivative valuation competences, the client has set out on creating alternatives, starting with the development of new methodological documentation and the prototype of a pricing platform.
Finalyse was to provide independent advise about how the current efforts could be scaled up to a complete derivative solution over the next years. The project covered schema and design for all instrument types used in a multi-curve framework for yield curve bootstrapping; the pricing of vanilla swaps and the choice of interface with source systems for both batch mode and excel interface. Typical outputs, besides the valuations, are cash flows forward value (in domestic currency), present value (in EUR), call probabilities for callable swaps and sensitivities for all trades.

Benefits of the provided solution

The past Valuations framework relied on a third-party software for all its pricing needs. This, over the years, has led to a number of unfulfilled key business needs. The development of an in-house independent pricing library, under the Derivatives Pricing Framework project lead to the following:

Increased transparency into the various methodology decisions, the architecture choices and various market, trade and reference data attributes.

• Improved accuracy of the valuations and help eliminate any backtesting failure as this in-house pricing library will be fit-for-purpose.
• Extended the derivatives division's flexibility to implement changes induce by the market or business developments.
• Offered a three Lines of Defence model across Front Office, RM and Internal Audit.
• Provided alignment with the BCBS 239 Principles for effective risk data aggregation and risk reporting.
• Lowered Total Cost of Ownership as compared to that for the third-party software solution, in the medium term.
• Lead to a better alignment with the bank’s and the department’s strategic priorities.
   

Key success factors

• Involvement of cross disciplinary team members
• Strong expertise in software engineering,  derivatives and bootstrapping and IFRS 9
• Application of Concepts for Derivatives Pricing Architecture (Caching, Sensivity Calculations, control flow etc.)