10.1 Overview of Transfer Pricing Option Costs

The purpose of option cost calculations is to quantify the cost of optionality, in terms of a spread over the transfer rate, for a single instrument. The cash flows of an instrument with an optionality feature change under different interest rate environments and thus should be priced accordingly.

For example, many mortgages may be prepaid by the borrower at any time without penalty. In effect, the lender has granted the borrower an option to buy back the mortgage at par, even if interest rates have fallen in value. Thus, this option has value.

In another case, an adjustable-rate loan may be issued with rate caps (floors) that limit it's maximum (minimum) periodic cash flows. These caps and floors constitute options. For the lender, the option cost of a cap is positive and negative for a floor.

Such flexibility given to the borrower raises the bank's cost of funding the loan and affects the underlying profit. The calculated cost of these options may be used in conjunction with the transfer rate to analyze profitability.

Oracle Funds Transfer Pricing uses the Monte Carlo methodology to calculate option costs. This methodology is described in Monte Carlo Analytics in the context of Oracle Asset Liability Management (ALM). Although Monte Carlo simulation in Oracle ALM generates different types of results than in Transfer Pricing, the underlying calculations are very similar.

In Oracle Funds Transfer Pricing, the option cost is calculated indirectly. Oracle Funds Transfer Pricing calculates and outputs two spreads:

• Static Spread
• Option-Adjusted Spread (OAS)

The option cost is defined by:

• Option Cost = Static Spread – OAS

In the theory section, we show that the static spread is equal to margin (credit spread) and the OAS to the risk-adjusted margin of an instrument. Therefore, the option cost quantifies the loss or gain due to risk.