Stochastic Transfer Pricing Process and Option Cost Parameters

11.6.8 Stochastic Transfer Pricing Process and Option Cost Parameters

In addition to transfer rates (created by a Standard TP Process), the Stochastic Transfer Pricing Process allows you to calculate the cost of options that are associated with your instruments. If you want to calculate option costs, you need to define the parameters used in option costing within the Stochastic Transfer Pricing Process.

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, the borrower can prepay many mortgages 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 a cost to the lender and should be priced accordingly.

In another case, an adjustable-rate loan may be issued with rate caps (or floors) which limit its maximum (or minimum) periodic cash flows. These caps and floors constitute options.

Such flexibility given to the borrower raises the bank's cost of funding the loan and will affect 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 technique to calculate the option cost. Oracle Funds Transfer Pricing calculates and outputs two spreads and the related option cost (rate) which is the difference between these two spreads. The spreads are as follows:

Static spread (HISTORIC_STATIC_SPREAD)
Option-adjusted spread (HISTORIC_OAS)

The option cost is derived as follows:

Option cost (rate) = OAS – Static Spread

The Option Cost calculation process will also compute the charge/credit amount using the Option Cost (rate), Average Balance, and Accrual Factor and will write the result to the following column:

CHARGE_CREDIT_OCOST

The static spread is equal to the margin and the OAS to the risk-adjusted margin of an instrument. Therefore, the option cost quantifies the loss or gain due to risk. For more information on Transfer Pricing Option Cost, see the OFS Cash Flow Engine Reference Guide.