Electronic copy available at: http://ssrn.com/abstract=1520618
A Market Model of Interest Rateswith Dynamic Basis Spreadsin the presence of Collateral and Multiple Currencies
, Yasufumi Shimada
, Akihiko Takahashi
First version: 12 November 2009Current version: 8 December 2009
The recent ﬁnancial crisis caused dramatic widening and elevated volatilities amongbasis spreads in cross currency as well as domestic interest rate markets. Furthermore,the wide spread use of cash collateral, especially in ﬁxed income contracts, has madethe eﬀective funding cost of ﬁnancial institutions for the trades signiﬁcantly diﬀerentfrom the Libor of the corresponding payment currency. Because of these marketdevelopments, the text-book style application of a market model of interest rates hasnow become inappropriate for ﬁnancial ﬁrms; It cannot even reﬂect the exposures tothese basis spreads in pricing, to say nothing of proper delta and vega (or kappa)hedges against their movements. This paper presents a new framework of the marketmodel to address all these issues.
Market Model, HJM model, Libor, tenor, swap, curve, OIS, cross currency,basis spread, interest rate model, derivatives, multi-currency
This research is supported by CARF (Center for Advanced Research in Finance) and the globalCOE program “The research and training center for new development in mathematics.” All the contentsexpressed in this research are solely those of the authors and do not represent the view of Shinsei Bank,Limited or any other institutions. The authors are not responsible or liable in any manner for any lossesand/or damages caused by the use of any contents in this research.
Graduate School of Economics, The University of Tokyo.M.F. is grateful for friends and former colleagues of Morgan Stanley, especially in IDEAS, IR option, andFX Hybrid desks in Tokyo for fruitful and stimulating discussions. The contents of the paper do notrepresent any views or opinions of Morgan Stanley.
Capital Markets Division, Shinsei Bank, Limited
Graduate School of Economics, The University of Tokyo