Two Curves, One Price:

Pricing & Hedging Interest Rate Derivatives Using

Different Yield Curves for Discounting and Forwarding
Marco Bianchetti∗
Risk Management, Market Risk, Pricing and Financial Modeling
Banca Intesa Sanpaolo, piazza P. Ferrari 10, 20121 Milan, Italy

Version 1.4, Jan. 29th, 2009

Abstract

In this paper we revisit the problem of pricing and hedging plain vanilla single-
currency interest rate derivatives using different yield curves for market coherent
estimation of discount factors and forward rates with different underlying rate tenors
(e.g. Euribor 3 months, 6 months,.etc.).
Within such double-curve-single-currency framework, adopted by the market
after the liquidity crisis started in summer 2007, standard single-curve no arbitrage
relations are no longer valid and can be formally recovered through the introduction
of a basis adjustment. Numerical results show that the basis adjustment curves
may display, in trouble market times, an oscillating micro-term structure, strongly
dependent on the quality of the bootstrapping. Such shapes may induce appreciable
effects on the price of interest rate instruments, in particular when people switches
from the single-curve towards the double-curve framework.
Recurring to the foreign-currency analogy we also derive the no arbitrage double-
curve market-like formulas for basic plain vanilla interest rate derivatives, FRA,
swaps, cap/floors and swaptions in particular. These expressions include an extra
quanto adjustment term typical of cross-currency derivatives, naturally originated
by the change between the numeraires associated to the two yield curves, that
carries on a volatility and correlation dependence. Numerical scenarios confirm that
such correction can be non-negligible, thus making the market prices, in principle,
∗
The author acknowledges fruitful discussions with M. De Prato, C. Maffi, F. Mercurio, N. Moreni,
M. Morini, M. Pucci and with many colleagues in the Risk Management. A particular mention is due
to F. Ametrano and to the QuantLib community for the open-source developements used to compute
the numerical results reported in the paper. The opinions expressed here are solely of the author and
do not represent in any way those of his employer.
 not arbitrage free. In practice arbitrage opportunities are hidden by the market
incompleteness.
JEL Classifications: E45, G13.
Keywords: liquidity, crisis, yield curve, forward curve, discount curve, pricing, hedg-
ing, interest rate derivatives, FRAs, swaps, basis swaps, caps, floors, swaptions,
basis adjustment, quanto adjustment, measure changes, no arbitrage.

Contents

1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
1.1 Single-Curve Pricing & Hedging Interest-Rate Derivatives . . . . . . . . 3
1.2 From Single to Double-Curve Paradigm . . . . . . . . . . . . . . . . . . 4
2 Double-Curve Framework, No Arbitrage and Basis Adjustment . . . . . . . . 7
2.1 General Assumptions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
2.2 Pricing Procedure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
2.3 No Arbitrage Revisited and Basis Adjustment . . . . . . . . . . . . . . . 10
3 Foreign-Currency Analogy and Quanto Adjustment . . . . . . . . . . . . . . . 12
3.1 Forward Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
3.2 Swap Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
4 Double-Curve Pricing & Hedging Interest Rate Derivatives . . . . . . . . . . . 19
4.1 Pricing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
4.2 Hedging . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21
5 Conclusions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22

1. Introduction

One of the many consequences of the liquidity crisis started in the second half of 2007 has
been a strong increase of the basis spreads quoted on the market between single-currency
interest rate instruments, swaps in particular, characterized by different underlying
rate tenors (e.g. Euribor3M1 , Euribor6M, etc.), reflecting the increased liquidity risk
and the corresponding preference of financial institutions for receiving payments with
higher frequency (quarterly instead of semi-annualy, for instance). Such asymmetry
has induced a sort of “segmentation” of the interest rate market into sub-areas, mainly
corresponding to instruments with 1M, 3M, 6M, 12M underlying rate tenors. Each area
is characterized, in principle, by its own internal dynamic, reflecting the different views
and interests of the market players.
In figs. 1.1, 1.2 we show a snapshot of the market quotations as of 30 Sep. 2008 (a
sensitive date for quarterly balance sheet results of financial institutions and industries)
1
Euro Interbank Offered Rate, the rate at which euro interbank term deposits within the euro zone
are offered by one prime bank to another prime bank (see e.g. www.euribor.org).

2
for six basis swap curves corresponding to the four Euribor tenors 1M, 3M, 6M, 12M.
As one can see, the basis spreads are monotonically decreasing from over 100 to around
4 basis points. There is neither way nor any good reason to ignore such quotations in a
market-coherent pricing framework of interest rate derivatives.
We stress that the present market situation described above is nothing else that
a new equilibrium configuration determined by the pressure of the increased illiquidity
force, that enlarges well known effects hystorically very small and traditionally neglected
before the crisis.

1.1. Single-Curve Pricing & Hedging Interest-Rate Derivatives

Such evolution of the financial markets has triggered a general reflection about the
methodology used to price and hedge interest rate derivatives, namely those financial
instruments whose price depends on the present value of future interest rate-linked
cashflows. The pre-crisis standard market practice (which does not automatically mean
good practice) can be summarized in the following procedure (see e.g. refs. [1]-[4]):

1. select one finite set of the most convenient (e.g. liquid) vanilla interest rate instru-
ments traded in real time on the market with increasing maturities; for instance,
a very common choice in the EUR market is a combination of short-term EUR
deposit, medium-term Futures on Euribor3M and medium-long-term swaps on
Euribor6M;

2. build one yield curve using the selected instruments plus a set of bootstrapping
rules (e.g. pillars, priorities, interpolation, etc.);

3. compute on the same curve forward rates, cashflows2 , discount factors and work
out the prices by summing up the discounted cashflows;

4. compute the delta sensitivity and hedge the resulting delta risk using the suggested
amounts (hedge ratios) of the same set of vanillas.

For instance, a 5.5Y maturity EUR floating swap leg on Euribor1M (not directly
quoted on the market) is commonly priced using discount factors and forward rates
calculated on the same depo-Futures-swap curve cited above. The corresponding delta
sensitivity is calculated by shoking one by one the curve pillars and the resulting delta
risk is hedged using the suggested amounts (hedge ratios) of 5Y and 6Y Euribor6M
swaps3 .
2
within the present context of interest rate derivatives we focus in particular on forward rate depen-
dent cashflows. See also eq. 2.11.
3
we refer here to the case of local yield curve bootstrapping methods, for which there are no sensitivity
delocalization effect (see refs. [1], [2]).

3
 We stress that this is a single-currency-single-curve approach, in that a unique curve
is built and used to price and hedge any interest rate derivative on a given currency.
Thinking in terms of more fundamental variables, e.g. the short rate, this is equivalent
to assume that there exist a unique fundamental underlying short rate process able to
model and explain the whole term structure of interest rates of any tenor.
It is also a relative pricing approach, because both the price and the hedge of a
derivative are calculated relatively to a set of vanillas quoted on the market. We notice
also that the procedure is not strictly guaranteed to be arbitrage-free, because discount
factors and forward rates obtained through interpolation are, in general, not necessarily
consistent with the no arbitrage condition; in practice bid-ask spreads and transaction
costs virtually hide any arbitrage possibility.
Finally, we stress that the first key point in the procedure above is much more a
matter of art than of science, because there is not an unique financially sound choice of
bootstrapping instruments and, in principle, none is better than the others.
The methodology described above can be extended, in principle, to more complicated
cases, in particular when a model of the underlying interest rate evolution is used to
calculate the future dynamic of the yield curve and the expected cashflows. The volatil-
ity and (eventually) correlation dependence carried by the model implies, in principle,
the bootstrapping of a variance/covariance matrix (two or even three dimensional) and
hedging the corresponding sensitivities (vega and rho) using volatility and correlation
dependent vanilla market instruments. In practice just a small subset of such quota-
tions is available on the market, and thus only some portions of the variance/covariance
matrix can be extracted from the market. In this note we will focus only on the basic
matter of yield curves and forget the volatility/correlation dimensions.

1.2. From Single to Double-Curve Paradigm

Unfortunately, the pre-crisis approach outlined above is no longer consistent, at least in
this simple formulation, with the present market configuration.
First, it does not take into account the market information carried by the basis swap
spreads, now much larger than in the past and no longer negligible.
Second, it does not take into account that the interest rate market is segmentated
into sub-areas corresponding to instruments with different underlying rate tenors, char-
acterized, in principle, by different dynamics (e.g. short rate processes). Thus, pricing
and hedging an interest rate derivative on a single yield curve mixing different under-
lying rate tenors can lead to “dirty” results, incorporating the different dynamics, and
eventually the inconsistencies, of different market areas, making prices and hedge ratios
less stable and more difficult to interpret. On the other side, the more the vanillas and
the derivative share the same homogeneous underlying rate, the better should be the
relative pricing and the hedging.

4
 Third, by no arbitrage, discounting must be univocal: two identical future cash-
flows of whatever origin must display the same present value; hence we need an unique
discounting curve.
The market practice has thus evolved to take into account the new market informa-
tions cited above, that translate into the additional requirement of homogeneity: as far
as possible, interest rate derivatives with a given underlying rate tenor should be priced
and hedged using vanilla interest rate market instruments with the same underlying.
The corresponding pricing procedure will be formalized and justified in sec. 2.2; we
summarize here the following modified working procedure:

1. build one discounting curve using the preferred procedure;

2. select multiple separated sets of vanilla interest rate instruments traded in real time
on the market with increasing maturities, each set homogeneous in the underlying
rate (typically with 1M, 3M, 6M, 12M tenors);

3. build multiple separated forwarding curves using the selected instruments plus
their bootstrapping rules;

4. compute on each forwarding curve the forward rates and the corresponding cash-
flows relevant for pricing derivatives on the same underlying;

5. compute the corresponding discount factors using the discounting curve and work
out prices by summing up the discounted cashflows;

6. compute the delta sensitivity and hedge the resulting delta risk using the suggested
amounts (hedge ratios) of the corresponding set of vanillas.

For instance, the 5.5Y floating swap leg cited in the previous section should be
priced using Euribor1M forward rates calculated on an “pure” 1M forwarding curve,
bootstrapped only on Euribor1M vanillas, plus discount factors calculated on the dis-
counting curve. The corresponding delta sensitivity should be calculated by shoking
one by one the pillars of both yield curves, and the resulting delta risk hedged using the
suggested amounts (hedge ratios) of 5Y and 6Y Euribor1M swaps plus the suggested
amounts of 5Y and 6Y instruments from the discounting curve (see sec. 4.2 for more
details about the hedging procedure).
The improved approach described above is more consistent with the present market
situation, but - there is no free lunch - it does demand much more additional efforts.
First, the discounting curve clearly plays a special and fundamental role, and must
be built with particular care. This “pre-crisis” obvious step has become, in the present
market situation, a very subtle and controversial point, that would require a whole paper
in itself. In fact, while the forwarding curves construction is driven by the underlying

5
rate tenor homogeneity principle, for which there is (now) a general market consensus,
there is no longer general consensus for the discounting curve construction. At least two
different practices can be encountered on the market: a) the old “pre-crisis” approach
(e.g. the depo, Futures and swap curve cited before), that can be justified with the
principle of maximum liquidity (plus a little of inertia), and b) the Eonia4 curve, justified
with no risky or collateralized counterparties, and by increasing liquidity (see e.g. the
discussion in ref. [5]). Second, building multiple curves requires multiple quotations:
much more interest rate bostrapping instruments must be considered (deposits, Futures,
swaps, basis swaps, FRAs, etc.), which are available on the market with different degrees
of liquidity and can display transitory inconsistencies. Third, non trivial interpolation
algorithms are crucial to produce smooth forward curves (see e.g. refs. [1]-[3]). Fourth,
multiple bootstrapping instruments implies multiple sensitivities, so hedging becomes
more complicated. Last but not least, pricing libraries, platforms, reports, etc. must
be extendend, configured, tested and released to manage multiple and separated yield
curves for forwarding and discounting, not a trivial task for quants, developers and IT
people.
In this paper we assume the existence of a convenient methodology (described in
detail in ref. [6]) for bootstrapping a discounting curve plus multiple forwarding curves
characterized by different underlying rate tenors (Euribor1M, 3M, 6M and 12M), and we
focus on the consequences for pricing and hedging interest rate derivatives. In particular
in sec. 2 we fix the notation, we revisit some general concept of standard, no arbitrage
single-curve pricing and we formulate the principles for double-curve pricing, showing
how no arbitrage can be formally recovered with the introduction of a basis adjustment.
In sec. 3 we use the foreign-currency analogy to derive a single-currency version of
the quanto adjustment (typical of cross-currency derivatives) to be applied to forward
rates. In sec. 4 we derive the no arbitrage double-curve pricing expression for basic
single-currency interest rate derivatives, zero coupon bonds, FRA, swaps and cap/floor
options in particular. Finally, in sec. 5 we summarize the conclusions.
Some of these topics have been approached also in other papers (see e.g. refs. [7]-
[12]). In particular W. Boenkost and W. Schmidt [9] discuss two methodologies for
pricing cross-currency basis swaps, the first of which (the actual pre-crisis common
market practice), does coincide, once reduced to the single-currency case, with the
double-curve pricing procedure described here. The concerns expressed by these authors,
that such approach was not arbitrage free and not consistent with the pre-crisis single-
curve market practice for pricing single-currency swaps, have now been overcome by
the market evolution towards a generalized double-curve pricing approach. Recently M.
Kijima et al. [10] have extended the approach of ref. [9] to the case of three curves for
4
Euro OverNight Index Average, the rate computed as a weighted average of all overnight
rates corresponding to unsecured lending transactions in the euro-zone interbank market (see e.g.
www.euribor.org).

6
discount factors, swap forward rates and bond forward rates, bootstrapped using swaps,
cross-currency swaps and governative bonds, respectively. Finally, simultaneously to the
drafting of the present paper, M. Morini [11] is approaching the same problem in terms
of counterparty risk, while F. Mercurio [12] is rebuilding the whole theory “from scratch”
in terms of modified Libor Market Model.
The present work is complementary to those cited before in the sense that: a) we
adopt a practitioner’s perspective, discussing in detail the current market practices
and keeping things as simple as possible; b) we explain why the market has evolved
from a single-curve towards a double-curve pricing framework in the case of single-
currency interest rate instruments (to our knowledge, this is discussed in detail only in
ref. [12]); c) we proof how non-arbitrage is broken-up and can be recovered in terms of
basis adjustment; d) we use the foreign-currency analogy to derive pricing formulas for
basic interest rate derivatives including the quanto adjustment arising from the change
between the numeraires (or probability measures) naturally associated to forwarding
and discounting curves; e) last but not least, we consistently keep together both pricing
and hedging issues, whose intimate connection is at the heart of quantitative finance,
trading and risk management.

2. Double-Curve Framework, No Arbitrage and Basis Adjustment

2.1. General Assumptions

We start by postulating the existence of two different interest rate markets, denoted by
Mx , x = {d, f }, characterized by the same currency and by two distinct bank accounts
Bx and yield curves {x in the form of a continuous term structure of discount factors,

{x = {T −→ Px (t0 , T ) , T ≥ t0 } , (2.1)

where t0 is the (common) reference date of the curves (e.g. settlement date, or today)
and Px (t, T ) denotes the price at time t ≥ t0 of the x -zero coupon bond for maturity
T , such that Px (T, T ) = 1.
Next we postulate the usual no arbitrage relation in each market Mx ,

Px (t, T2 ) = Px (t, T1 ) × Px (t, T1 , T2 ) , (2.2)

where t ≤ T1 < T2 and Px (t, T1 , T2 ) denotes the forward discount factor from time T2
to time T1 , prevailing at time t. The financial meaning of expression 2.2 is that, in each
market Mx , given a cashflow of one unit of currency at time T2 , its corresponding value
at time t < T2 must be the same both if we discount in one single step from T2 to t, using
the discount factor Px (t, T2 ), and if we discount in two steps, first from T2 to T1 , using
the forward discount Px (t, T1 , T2 ) and then from T1 to t, using Px (t, T1 ). Denoting with

7
Fx (t; T1 , T2 ) the simple compounded forward rate associated to Px (t, T1 , T2 ), resetting
at time T1 and covering the time interval [T1 ; T2 ], we have

Px (t, T2 ) 1
Px (t, T1 , T2 ) = = , (2.3)
Px (t, T1 ) 1 + Fx (t; T1 , T2 ) τ x (T1 , T2 )

where τ x (T1 , T2 ) is the year fraction between times T1 and T2 with daycount dcx , from
eq. 2.2 we obtain the familiar no arbitrage expression
∙ ¸
1 1
Fx (t; T1 , T2 ) = −1
τ x (T1 , T2 ) Px (t, T1 , T2 )
Px (t, T1 ) − Px (t, T2 )
= . (2.4)
τ x (T1 , T2 ) Px (t, T2 )

Eq. 2.4 can be also derived (see e.g. ref. [13], par. 1.4) as the fair value condition at
time t of the Forward Rate Agreement (FRA) contract with payoff at maturity T2 given
by

FRA (T2 ; T1 , T2 , K, N ) = N τ x (T1 , T2 ) [Lx (T1 , T2 ) − K] , (2.5)

1 − Px (T1 , T2 )
Lx (T1 , T2 ) = (2.6)
τ x (T1 , T2 ) Px (T1 , T2 )

where N is the nominal amount, Lx (T1 , T2 , dcx ) is the T1 -spot Euribor rate and K the
(simply compounded) strike rate (sharing the same daycount convention for simplicity).
Introducing expectations we have, ∀t ≤ T1 < T2 ,
T2
FRA (t; T1 , T2 , K, N ) = Px (t, T2 ) EQ
t
x
[FRA (T2 ; T1 , T2 , K, N )]
½ ¾
T
Qx2
= N Px (t, T2 ) τ x (T1 , T2 ) Et [Lx (T1 , T2 )] − K

= N Px (t, T2 ) τ x (T1 , T2 ) [Fx (t; T1 , T2 ) − K] , (2.7)

where QTx2 denotes the Mx -T2 -forward measure, EQ

t [.] denotes the expectation at time
t w.r.t. measure Q and filtration Ft (encoding the market information available up to
time t), and we have used the standard martingale property of forward rates

T2 T2
Fx (t; T1 , T2 ) = EQ
t
x
[Fx (T1 ; T1 , T2 )] = EQ
t
x
[Lx (T1 , T2 )] (2.8)

holding in each interest rate market Mx .

8
2.2. Pricing Procedure
Now we consider any derivative written on a single underlying interest rate with n future
coupons with payoffs π = {π 1 , ..., π n }, generating n cashflows c = {c1 , ..., cn } at future
dates T = {T1 , ..., Tn }, t < T1 < ... < Tn . Following the discussion in sec. 1.2, we
postulate the following generalized, double-curve-single-currency pricing procedure:

1. assume {d as the discounting curve and {f as the forwarding curve;

2. calculate any relevant spot/forward rate on the forwarding curve {f as
1 − Pf (t, Ti )
Lf (t, Ti ) = , t < Ti , (2.9)
τ f (t, Ti ) Pf (t, Ti )
Pf (t, Ti−1 ) − Pf (t, Ti )
Ff (t; Ti−1 , Ti ) = , t ≤ Ti−1 < Ti , (2.10)
τ f (Ti−1 , Ti ) Pf (t, Ti )

3. calculate cashflows ci , i = 1, ..., n, as expectations of the i-th coupon payoff π i

with respect to the discounting Ti -forward measure QTd i ,
T
Qd i
ci = c (t, Ti , π i ) = Et [π i ] ; (2.11)

4. calculate the price at time t by discounting each cashflow c (t, Ti , π i ) using the
corresponding discount factor Pd (t, Ti ) obtained from the discounting curve {d
and summing up,
n
X
π (t; T) = Pd (t, Ti ) c (t, Ti , π i )
i=1
n
X T
Qd i
= Pd (t, Ti ) Et [π i ] . (2.12)
i=1

Notice that steps 3 and 4 above have been formulated in terms of the particular
pricing measure QTd i associated to the numeraire Pd (t, Ti ). This is convenient in our
context because it emphasizes that discounting must be associated to the discounting
curve. Obviously they can be reformulated in terms of any other equivalent measure
associated to different numeraires.
If we apply the paradigm above to the FRA case, we obtain that the single-curve
FRA price in eq. 2.7 traslates into the following generalized, double-curve expression
½ T ¾
Q 2
FRA (t; T1 , T2 , K, N ) = N Pd (t, T2 ) τ f (T1 , T2 ) Et d [Ff (T1 ; T1 , T2 )] − K . (2.13)

We will compute such expectation in par. 3.

9
2.3. No Arbitrage Revisited and Basis Adjustment
The first consequence of the assumptions above is that, clearly, standard single-curve
no arbitrage relations such as eq. 2.4 are broken up, being

Pd (t, T2 ) 1
Pd (t, T1 , T2 ) = =
Pd (t, T1 ) 1 + Fd (t; T1 , T2 ) τ d (T1 , T2 )
1 Pf (t, T2 )
6= = = Pf (t, T1 , T2 ) . (2.14)
1 + Ff (t; T1 , T2 ) τ f (T1 , T2 ) Pf (t, T1 )

Clearly, no arbitrage is immediately recovered by postulating the following generalized

double-curve no arbitrage relation

Pd (t, T2 )
Pd (t, T1 , T2 ) =
Pd (t, T1 )
1
= , (2.15)
1 + Ff (t; T1 , T2 ) BAf d (t, T1 , T2 ) τ f (T1 , T2 )

or the equivalent simple transformation rule for forward rates

Fd (t; T1 , T2 ) = Ff (t; T1 , T2 ) BAf d (t, T1 , T2 ) . (2.16)

We call the conversion factor BAf d (t, T1 , T2 ) in eqs. 2.15-2.16 (forward) basis adjust-
ment. From eq. 2.16 we can express it as a ratio between forward rates or, equivalently,
in terms of discount factors from {d and {f curves as

Fd (t; T1 , T2 )
BAf d (t, T1 , T2 ) =
Ff (t; T1 , T2 )
τ f (T1 , T2 ) Pf (t, T2 ) Pd (t, T1 ) − Pd (t, T2 )
= . (2.17)
τ d (T1 , T2 ) Pd (t, T2 ) Pf (t, T1 ) − Pf (t, T2 )

Notice that if {d = {f we recover the single-curve case BAf d (t, T1 , T2 ) = 1.

In eq. 2.16 we have chosen a multiplicative definition of the basis adjustment.
Obviously the alternative additive definition is completely equivalent

BA0f d (t, T1 , T2 ) = Fd (t; T1 , T2 ) − Ff (t; T1 , T2 )

Pd (t, T1 ) − Pd (t, T2 ) Pf (t, T1 ) − Pf (t, T2 )
= −
τ d (T1 , T2 ) Pd (t, T2 ) τ f (T1 , T2 ) Pf (t, T2 )
= Ff (t; T1 , T2 ) [BAf d (t, T1 , T2 ) − 1] . (2.18)

The latter is more useful for comparisons with the market basis spreads of figs. 1.1-1.2.

10
 We stress that the basis adjustment in eqs. 2.17-2.18 is a straightforward conse-
quence of the assumptions above, essentially the existence of two curves and no arbi-
trage. In practice its value depends on the basis spread between the quotations of the
two sets of vanilla instruments used in the bootstrapping of the two curves {d and {f .
The advantage of expressions 2.17, 2.18 is that they allows for a direct computation of
the basis adjustment between forward rates for any time interval [T1 , T2 ], which is the
relevant quantity for pricing and hedging interest rate derivatives. On the other side,
the limit of expression 2.17-2.18 is that they reflects the statical 5 differences between
the two interest rate markets Md , Mf carried by the two curves {d , {f , but they are
completely independent of the interest rate dynamics in Md and Mf .
Notice also that, in principle, we can also use our approach to bootstrap a new yield
curve from a given yield curve plus a given basis adjustment. Inverting eq. 2.17 we
obtain the following recursive relations
τ f,i Pf,i
Pd,i = Pd,i−1
τ d,i [Pf,i−1 − Pf,i ] BAf d,i + τ f,i Pf,i−1
τ f,i Pf,i
= Pd,i−1 , (2.19)
τ d,i [Pf,i−1 − Pf,i ] + τ d,i τ f,i Pf,i BA0f d,i + τ f,i Pf,i−1
τ d,i Pd,i BAf d,i
Pf,i = Pf,i−1
τ f,i [Pd,i−1 − Pd,i ] + τ d,i Pd,i−1 BAf d,i
τ d,i Pd,i
= Pf,i−1 , (2.20)
τ d,i Pd,i + τ f,i [Pd,i−1 − Pd,i ] − τ d,i τ f,i Pd,i BA0f d,i

where we have shortened the notation by putting τ x (Ti−1 , Ti ) = τ x,i , Px (t, Ti ) = Px,i ,
BAf d (t, Ti−1 , Ti ) = BAf d,i . Given the yield curve up to step Px,i−1 plus the basis
adjustment for the step i − 1 → i, the equations above can be used to obtain the next
step Px,i .
We now discuss a numerical example of the basis adjustment in a realistic market
situation. We consider the four interest rate underlyings I = {I1M , I3M , I6M , I12M },
where I = Euribor index, and we bootstrap from market data five separated yield
curves { = {{d , {If1M , {If2M , {If6M , {If12M }, using the first one for discounting and the
others for forwarding. We follow the methodology described in ref. [6] and we use the
corresponding open-source development in the QuantLib framework [14]. The discount-
ing curve {d is built following a typical “pre-crisis” standard recipe from the most liquid
deposit, 3M Futures and 6M swap contracts; the other curves are built from mixings of
depos, FRAs, Futures, swaps and basis swaps with homogeneous underlying rate tenors;
a smooth algorithm (monotonic cubic spline on log discounts) is used for interpolations6 .
5
we remind that the discount factors in eqs. 2.17-2.17 are calculated on the curves {d , {f following
the recipe described in sec. 2.2, not using any dynamical model for the evolution of the rates.
6
technicalities of the curves construction are not crucial in the present context.

11
 In fig. 2.1 we plot the 6M-tenor forward rates calculated on {d and {If6M as of 15
Sept. 2008, end of day. This is an highly stressed market period, just at the Lehman
default and after the Fannie Mae and Freddie Mac federal takeover (Sep. 8, 2008). The
effects of such main market events are clearly visible in the crazy roller-coaster look-up
of the curves. The small differences in the two short-term structures derive from the
use of different market instruments in the two bootstrappings, while the medium and
long-term similarity is due to the common use of 6M swap quotes. Similar patterns are
observed also in the other 1M, 3M, 12M curves (not reported here).
In fig. 2.2 (upper panels) we plot the term structure of the four corresponding
multiplicative basis adjustment curves calculated through eq. 2.17. In the lower panels
we also plot the additive basis ajustment given by eq. 2.18. The higher short-term
basis adjustments (left panels) are due to the higher short-term market basis spreads
(see Figs. 1.1-1.2). We observe in particular that the medium-long-term {If6M − {d
basis (dash-dotted green lines in the right panels) are close to 1 and 0, respectively, as
expected from the common use of 6M swaps. A similar, but less evident, behaviour
is found in the short-term {If3M − {d basis (continuous blue line in the left panels), as
expected from the common 3M Futures and the uncommon deposits. The two remaining
basis curves {If1M − {d and {If12M − {d are generally far from 1 or 0 because of different
bootstrapping instruments. Obviously such details depend on our arbitrary choice of
the discounting curve.
Overall, we notice that all the basis curves {xf − {d reveal a complex micro-term
structure, not present in the smooth and monotonic basis swaps market quotes of figs.
1.1-1.2, essentially due to an amplification effect of small local differences between the
{d and {xf yield curves. In general, such richer term structure is a very sensitive test
of the quality of the bootstrapping procedure (interpolation in particular), and also an
indicator of the tiny, but observable, differences between different interest rate market
areas. Obviously these causes may have appreciable effects on the price of similar
interest rate instruments. We can appreciate in fig. 2.3 the perverse effects of a non
smooth bootstrapping (linear interpolation on zero rates, a common market practice).
The angular points in the lower panel clearly show the inadequacy of the bootstrap,
but the very strong oscillations in the (additive) basis adjustment in the upper panel
(notice the different scales w.r.t. fig. 2.2, lower panels) allows to further appreciate the
unnatural differences induced in similar forward instruments priced on the two curves.

3. Foreign-Currency Analogy and Quanto Adjustment

We come now to the problem of calculating expectations as in eq. 2.12 in general and
2.13 in particular. This will involve the dynamical properties of the two interest rate
markets Md and Mf , or, in other words, will require to model the dynamics for the
interest rates in Md and Mf . This task is easily accomplished by recurring to the

12
natural analogy with cross-currency derivatives. Going back to the beginning of sec.
2, we can identify Md and Mf with the domestic and foreign markets, {d and {f with
the corresponding curves, and the bank accounts Bd (t), Bf (t) with the corresponding
currencies, respectively7 . Within this framework, we can recognize on the r.h.s of eq.
2.15 the forward discount factor from time T2 to time T1 expressed in domestic currency,
and on the r.h.s. of eq. 2.13 the expectation of the foreign forward rate w.r.t the domestic
forward measure. Hence, the computation of such expectation must involve the quanto
adjustment commonly encountered in the pricing of cross-currency derivatives. The
derivation of such adjustment can be found in standard textbooks. Anyway, in order
to fully appreciate the parallel with the present double-curve-single-currency case, it is
useful to run through it once again. In particular, we will adapt to the present context
the discussion found in ref. [13], chs. 2.9 and 14.4.

3.1. Forward Rates

In the double—curve-double-currency case, no arbitrage requires the existence at any
time t0 ≤ t ≤ T of a spot and a forward exchange rate between equivalent amounts of
money in the two currencies such that

cd (t) = xf d (t) cf (t) , (3.1)

Xf d (t, T ) Pd (t, T ) = xf d (t) Pf (t, T ) , (3.2)

where the subscripts f and d stand for foreign and domestic, cd (t) is any cashflow
(amount of money) at time t in units of domestic-currency and cf (t) is the corresponding
cashflow at time t (the corresponding amount of money) in units of foreign currency.
Obviously Xf d (t, T ) → xf d (t) for t → T . Expression 3.2 is a direct consequence of
no arbitrage. This can be understood with the aid of fig. 3.1: starting from top right
corner in the time vs currency/yield curve plane with an unitary cashflow at time T > t
in foreign currency, we can either move along path A by discounting at time t on
curve {f using Pf (t, T ) and then by changing into domestic currency units using the
spot exchange rate xf d (t), ending up with xf d (t) Pf (t, T ) units of domestic currency;
or, alternatively, we can follow path B by changing at time T into domestic currency
units using the forward exchange rate Xf d (t, T ) and then by discounting on {d using
Pd (t, T ), ending up with Xf d (t, T ) Pd (t, T ) units of domestic currency. Both paths stop
at bottom left corner, hence eq. 3.2 must hold by no arbitrage.
Our double-curve-single-currency case is immediately obtained from the discussion
above by thinking to the subscripts f and d as shorthands for forwarding and discounting
and by recognizing that, having a single currency, the spot exchange rate must collapse
7
notice the lucky notation: “d ” stands either for “discounting” or“domestic” and “f ” for “forward-
ing” or “foreign”, respectively.

13
to 1. We thus have

xf d (t) = 1, (3.3)
Pf (t, T )
Xf d (t, T ) = . (3.4)
Pd (t, T )
Obviously for {d = {f we recover the single-currency, single-curve case Xf d (t, T ) = 1 ∀
T . The interpretation of the forward exchange rate in eq. 3.4 within this framework is
straightforward: it is nothing else that the counterparty of the (forward) basis adjust-
ment in eq. 2.16 for discount factors on the two yield curves {d and {f . They satisfy
the following relation

τ f (T1 , T2 )
BAf d (t, T1 , T2 ) = Xf d (t, T2 )
τ d (T1 , T2 )
Pd (t, T1 ) − Pd (t, T2 )
× . (3.5)
Pd (t, T1 ) Xf d (t, T1 ) − Pd (t, T2 ) Xf d (t, T1 )
Notice that we could forget the foreign currency analogy above and start by postulating
Xf d (t, T ) as in eq. 3.4, name it (discount) basis adjustment and proceed with the next
step.
We proceed by assuming, according to the standard market practice, the following
(driftless) lognormal martingale dynamic for the {f (foreign) forward rate
dFf (t; T1 , T2 )
= σ f (t) dWfT2 (t) , t ≤ T1 , (3.6)
Ff (t; T1 , T2 )
where σ f (t) is the volatility³ (positive deterministic
´ function of time) of the process,
under the probability space Ω, F , Qf with the filtration Ftf generated by the brow-
f T2

nian motion WfT2 under the forwarding (foreign) T2 −forward measure QTf 2 , associated
to the {f (foreign) numeraire Pf (t, T2 ).
Next, since Xf d (t, T2 ) in eq. 3.4 is the ratio between the price at time t of a {d
(domestic) tradable asset (xf d (t) Pf (t, T2 ) in eq. 3.2, or Pf (t, T2 ) in eq. 3.4 with
xf d (t) = 1) and the numeraire Pd (t, T2 ), it must evolve according to a (driftless) mar-
tingale process under the associated discounting (domestic) T2 −forward measure QTd 2 ,

dXf d (t, T2 ) T2
= σ X (t) dWX (t) , t ≤ T2 , (3.7)
Xf d (t, T2 )
where σ X (t) is the volatility (positive deterministic function of time) of the process and
T2
WX is a brownian motion under QTd 2 such that

dWfT2 (t) dWXT2 (t) = ρf X (t) dt. (3.8)

14
 Now, in order to calculate expectations such as in the r.h.s. of eq. 2.13, we must
switch from the forwarding (foreign) measure QTf 2 associated to the numeraire Pf (t, T2 )
to the discounting (domestic) measure QTd 2 associated to the numeraire Pd (t, T2 ). In our
double-curve-single-currency language this amounts to transform a cashflow on curve
{f to the corresponding cashflow on curve {d . Recurring to the change-of-numeraire
tecnique (cfr. refs. [13], [15], [16]) we obtain that the dynamic of Ff (t; T1 , T2 ) under
QTd 2 acquires a non-zero drift

dFf (t; T1 , T2 )
= µf (t) dt + σ f (t) dWfT2 (t) , t ≤ T1 , (3.9)
Ff (t; T1 , T2 )
µf (t) = −σ f (t) σ X (t) ρf X (t) , (3.10)

and that Ff (T1 ; T1 , T2 ) is lognormally distributed under QTd 2 with mean and variance
given by
T
∙ ¸ Z T1 ∙ ¸
Qd 2 Ff (T1 ; T1 , T2 ) 1 2
Et ln = µf (u) − σ f (u) du, (3.11)
Ff (t; T1 , T2 ) t 2
T
∙ ¸ Z T1
Qd 2 Ff (T1 ; T1 , T2 )
Vart ln = σ 2f (u) du. (3.12)
Ff (t; T1 , T2 ) t

We thus obtain the following expressions, for t0 ≤ t < T1 ,

T
Q 2 ¡ ¢
Et d [Ff (T1 ; T1 , T2 )] = Ff (t; T1 , T2 ) QAf d t, T1 , σ f , σ X , ρf X , (3.13)
¡ ¢ R T1 R T1
QAf d t, T1 , σ f , σ X , ρf X = e t µf (u)du = e− t σf (u)σX (u)ρf X (u)du . (3.14)

We conclude that the foreign-currency analogy allows us to compute the expectation

of a forward rate on curve {f w.r.t. the discounting measure QTd 2 associated to the
discounting curve {d through the numeraire Pd (t, T2 ) in terms of a well-known quanto
adjustment, typical of cross-currency derivatives. From the discussion above it is clear
that such adjustment essentially follows from a change between the probability measures
QTf 2 and QTd 2 , or numeraires Pf (t, T2 ) and Pd (t, T2 ), naturally associated to the two yield
curves, {f and {d , respectively.
Obviously we can also define an additive quanto adjustment as
T
Q 2 ¡ ¢
Et d [Ff (T1 ; T1 , T2 )] = Ff (t; T1 , T2 ) + QA0f d t, T1 , σ f , σ X , ρf X , (3.15)
¡ ¢ £ ¡ ¢ ¤
QA0f d t, T1 , σ f , σ X , ρf X = Ff (t; T1 , T2 ) QAf d t, T1 , σ f , σ X , ρf X − 1 , (3.16)

where the second relation comes from eq. 3.13. Notice that the expressions 3.14 depends
on the average over the time interval [t, T1 ] of the product of the volatility σ f of the

15
{f (foreign) forward rates Ff , of the volatility σ X of the forward exchange rate Xf d
between curves {f and {d , and of the correlation ρf X between Ff and Xf d . It does
not depend either on the volatility σ d of the {d (domestic) forward rates Fd or on any
stochastic quantity after time T1 . The latter fact is actually quite natural, because the
stochasticity of the forward rates involved ceases at their fixing time T1 . The dependence
on the cashflow time T2 is actually implicit in eq 3.14, because the volatilities and the
correlation involved are exactly those of the forward and exchange rates on the time
interval [T1 , T2 ]. Notice in particular that a non-trivial adjustment is obtained if and
only if the forward exchange rate Xf d is stochastic (σ X 6= 0) and correlated to the
forward rate Ff (ρf X 6= 0); otherwise expression 3.14 collapses to the single curve case
QAf d = 1.
The volatilities and the correlation in eq. 3.14 can be extracted from market data.
In the present market situation, the volatility σ f can be extracted from quoted cap/floor
options on Euribor6M, while for other rate tenors and for σ X and ρf X one must resort
to historical estimates. Conversely, given a basis adjustment term structure, such that
in fig. 2.2, we could take σ f from the market, assume for simplicity ρf X ' 1 (or any
other functional form), and bootstrap out a term structure for the volatility σ X . Notice
that in this way we are also able to compare informations about the internal dynamics
of different market sub-areas. We will give some numerical estimate of the quanto
adjustment in the next section.
Finally, we may derive a relation between the quanto and the basis adjustments.
Combining eqs. 3.13, 3.15 with eqs. 2.17, 2.18 we obtain

T2
Q
BAf d (t, T1 , T2 ) E d [L (T , T )]
¡ ¢ = t T2 d 1 2 , (3.17)
QAf d t, T1 , σ f , σ X , ρf X Q
Et d [Lf (T1 , T2 )]
¡ ¢ T
Q 2
BA0f d (t, T1 , T2 ) − QA0f d t, T1 , σ f , σ X , ρf X = Et d [Ld (T1 , T2 ) − Lf (T1 , T2 )] (3.18)

3.2. Swap Rates

The discussion above can be remapped, with some attention, to swap rates. Given two
payment dates vectors T = {T0 , ..., Tn }, S = {S0 , ..., Sm }, T0 = S0 , for the floating and
the fixed leg of the swap, respectively, the corresponding fair swap rate on curve {f is
defined as

P
n
Pf (t, Ti ) τ f (Ti−1 , Ti ) Ff (t; Ti−1 , Ti )
i=1
Sf (t, T, S) = , t ≤ T0 , (3.19)
Af (t, S)

16
where
m
X
Af (t, S) = Pf (t, Sj ) τ f (Sj−1 , Sj ) (3.20)
j=1

is the annuity on curve {f . Following the standard market practice, we observe that,
assuming the annuity as the numeraire, the swap rate in eq. 3.19 is the ratio between
a tradable asset (the value of the swap floating leg on curve {f ) and the numeraire
Af (t, S), and thus it is a martingale under the associated forwarding (foreign) swap
measure QSf . Hence we can assume, mimicking eq. 3.6, a driftless geometric brownian
motion for the swap rate under QSf ,

dSf (t, T, S)
= ν f (t, T, S) dWfT,S (t) , t ≤ T0 , (3.21)
Sf (t, T, S)

where υ f (t, T, S) is the volatility (positive deterministic function of time) of the process
and WfT,S is a brownian motion under QSf .
Then, mimicking the discussion leading to eqs. 3.3-3.4, the following identity
m
X m
X
Pd (t, Sj ) τ d (Sj−1 , Sj ) Xf d (t, Sj ) = xf d (t) Pf (t, Sj ) τ f (Sj−1 , Sj )
j=1 j=1
= Af (t, S) , (3.22)

must hold by no arbitrage between the two curves {f and {d . Defining a swap forward
exchange rate Yf d (t, S) such that
m
X m
X
Pd (t, Sj ) τ d (Sj−1 , Sj ) Xf d (t, Sj ) = Yf d (t, S) Pd (t, Sj ) τ d (Sj−1 , Sj )
j=1 j=1
= Yf d (t, S) Ad (t, S) , (3.23)

we obtain the expression

Af (t, S)
Yf d (t, S) = , (3.24)
Ad (t, S)
equivalent to eq. 3.4. Hence, since Yf d (t, S) is the ratio between the price at time t
of the {d (domestic) tradable asset xf d (t) Af (t, S) and the numeraire Ad (t, S), it must
evolve according to a (driftless) martingale process under the associated discounting
(domestic) swap measure QSd ,

dYf d (t, S)
= ν Y (t, S) dWYS (t) , t ≤ T0 , (3.25)
Yf d (t, S)

17
where vY (t, S) is the volatility (positive deterministic function of time) of the process
and WYS is a brownian motion under QSd such that

dWfT,S (t) dWYS (t) = ρf Y (t, T, S) dt. (3.26)

Now, applying again the change-of-numeraire tecnique of sec. 3.1, we obtain that the
dynamic of the swap rate Sf (t, T, S) under the discounting (domestic) swap measure
QSd acquires a non-zero drift

dSf (t, T, S)
= λf (t, T, S) dt + ν f (t, T, S) dWfT,S (t) , t ≤ T0 , (3.27)
Sf (t, T, S)
λf (t, T, S) = −ν f (t, T, S) ν Y (t, S) ρf Y (t, T, S) , (3.28)

and that Sf (t, T, S) is lognormally distributed under QSd with mean and variance given
by
∙ ¸ Z T0 ∙ ¸
QS Sf (T0 , T, S) 1
Et d
ln = λf (u, T, S) − ν 2f (u, T, S) du, (3.29)
Sf (t, T, S) t 2
∙ ¸ Z T0
QS Sf (T0 , T, S)
Vart d ln = ν 2f (u, T, S) du. (3.30)
Sf (t, T, S) tf

We thus obtain the following expressions, for t0 ≤ t < T0 ,

QS
d
¡ ¢
Et [Sf (T0 , T, S)] = Sf (t, T, S) QAf d t, T, S, ν f , ν Y , ρf Y , (3.31)
¡ ¢ R T0 R T0
QAf d t, T, S, ν f , ν Y , ρf Y = e t λf (u,T,S)du = e− t ν f (u,T,S)ν Y (u,S)ρf Y (u,T,S)du .
(3.32)

The same considerations as in sec. 3.1 apply. In particular, we observe that the
adjustment in eqs. 3.31, 3.33 follows from a change between the probability measures
QSf and QSd , or numeraires Af (t, S) and Ad (t, S), naturally associated to the two yield
curves, {f and {d , respectively, once swap rates are considered. In the present market
situation, the volatility ν f (u, T, S) in eq. 3.32 can be extracted from quoted swaptions
on Euribor6M, while for other rate tenors and for ν Y (u, S) and ρf Y (u, T, S) one must
resort to historical estimates.
An additive quanto adjustment can also be defined as before

QS ¡ ¢
Et [Sf (T0 , T, S)] = Sf (t, T, S) + QA0f d t, T, S, ν f , ν Y , ρf Y ,
d
(3.33)
¡ ¢ £ ¡ ¢ ¤
QA0f d t, T, S, ν f , ν Y , ρf Y = Sf (t, T, S) QAf d t, T, S, ν f , ν Y , ρf Y − 1 . (3.34)

18
4. Double-Curve Pricing & Hedging Interest Rate Derivatives

4.1. Pricing
The discussion above allows us to derive the no arbitrage, double-curve-single-currency
pricing formulas for interest rate derivatives. The recipes are, basically, eqs. 3.13-3.14
or 3.31-3.32.
The simplest interest rate derivative is a floating zero coupon bond paying at time
T a single cashflow depending on a single spot rate (e.g. the Euribor) fixed at time
t < T,
ZCB (T ; T, N ) = N τ f (t, T ) Lf (t, T ) . (4.1)
Being
1 − Pf (t, T )
Lf (t, T ) = = Ff (t; t, T ) , (4.2)
τ f (t, T ) Pf (t, T )
the price at time t ≤ T is given by
QT
d
ZCB (t; T, N ) = N Pd (t, T ) τ f (t, T ) Et [Ff (t; t, T )]
= N Pd (t, T ) τ f (t, T ) Lf (t, T ) . (4.3)

Notice that the basis adjustment in eq. 4.3 disappears and we are left with the standard
pricing formula, modified according to the double-curve paradigm.
Next we have the FRA, whose payoff is given in eq. 2.5 and whose price at time
t ≤ T1 is given by
½ T ¾
Qd 2
FRA (t; T1 , T2 , K, N ) = N Pd (t, T2 ) τ f (T1 , T2 ) Et [Ff (T1 ; T1 , T2 )] − K
£ ¡ ¢ ¤
= N Pd (t, T2 ) τ f (T1 , T2 ) Ff (t; T1 , T2 ) QAf d t, T1 , ρf X , σ f , σ X − K . (4.4)

Notice that in eq. 4.4 for K = 0 and T1 = t we recover the zero coupon bond price in
eq. 4.3.
For a (payer) floating vs fixed swap with payment dates vectors T, S as in sec. 3.2
we have the price at time t ≤ T0

Swap (t; T, S, K, N)
Xn
¡ ¢
= Ni Pd (t, Ti ) τ f (Ti−1 , Ti ) Ff (t; Ti−1 , Ti ) QAf d t, Ti−1 , ρf X,i , σ f,i , σ X,i
i=1
Xm
− Nj Pd (t, Sj ) τ d (Sj−1 , Sj ) Kj . (4.5)
j=1

19
For constant nominal and fixed rate the fair (equilibrium) swap rate is given by
P
n ¡ ¢
Pd (t, Ti ) τ f (Ti−1 , Ti ) Ff (t; Ti−1 , Ti ) QAf d t, Ti−1 , ρf X,i , σ f,i , σ X,i
i=1
Sf (t, T, S) = ,
Ad (t, S)
(4.6)
where
m
X
Ad (t, S) = Pd (t, Sj ) τ d (Sj−1 , Sj ) (4.7)
j=1

is the annuity on curve {d .

For caplet/floorlet options on a T1 -spot rate with payoff at maturity T2 given by

cf (T2 ; T1 , T2 , K, ω,N ) = N Max {ω [Lf (T1 , T2 ) − K]} τ f (T1 , T2 ) , (4.8)

the standard market-like pricing expression at time t ≤ T1 ≤ T2 is modified as follows

T
Qd 2
cf (t; T1 , T2 , K, ω,N ) = N Et [Max {ω [Lf (T1 , T2 ) − K]} τ f (T1 , T2 )]
£ ¡ ¢ ¤
= N Pd (t, T2 ) τ f (T1 , T2 ) Bl Ff (t; T1 , T2 ) QAf d t, T1 , ρf X , σ f , σ X , K, µf , σ f , ω ,
(4.9)

where ω = +/ − 1 for caplets/floorlets, respectively, and

£ ¡ ¢ ¡ ¢¤
Bl [F, K, µ, σ, ω] = ω F Φ ωd+ − KΦ ωd− , (4.10)
F 1 2
ln + µ (t, T ) ± 2 σ (t, T )
d± = K
, (4.11)
σ (t, T )
Z T Z T
2
µ (t, T ) = µ (u) du, σ (t, T ) = σ 2 (u) du, (4.12)
t t

is the standard Black-Scholes formula. Hence cap/floor options prices are given at t ≤ T0
by
n
X
CF (t; T, K, ω, N) = cf (Ti ; Ti−1 , Ti , Ki , ω i ,Ni )
i=1
n
X
= Ni Pd (t, Ti ) τ f (Ti−1 , Ti )
i=1
£ ¡ ¢ ¤
× Bl Ff (t; Ti−1 , Ti ) QAf d t, Ti−1 , ρf X,i , σ f,i , σ X,i , Ki , µf,i , σ f,i , ωi , (4.13)

Finally, for swaptions on a T0 -spot swap rate with payoff at maturity T0 given by

Swaption (T0 ; T, S, K, N ) = NMax [ω (Sf (T0 , T, S) − K)] Ad (T0 , S) , (4.14)

20
the standard market-like pricing expression at time t ≤ T0 , using the discounting swap
measure QSd associated to the numeraire Ad (t, S) on curve {d , is modified as follows

QS
Swaption (t; T, S, K, N ) = N Ad (t, S) Et d {Max [ω (Sf (T0 , T, S) − K)]}
£ ¡ ¢ ¤
= N Ad (t, S) Bl Sf (t, T, S) QAf d t, T, S, ν f , ν Y , ρf Y , K, λf , ν f , ω . (4.15)
¡ ¢
where we have used eq. 3.31 and the quanto adjustment term QAf d t, T, S, ν f , ν Y , ρf Y
is given by eq. 3.32.
When two or more different underlying interest-rates are present, pricing expressions
may become more involved. An example is the spread option, for which the reader can
refer to, e.g., ch. 14.5.1 in ref. [13]).
The calculations above show that also basic interest rate derivatives prices include
a quanto adjustment and are thus volatility and correlation dependent. In fig. 4.1 we
show some numerical scenario for the quanto adjustment in eqs. 3.14, 3.16. We see
that, for realistic values of volatilities and correlation, the magnitudo of the additive
adjustment may be non negligible, ranging from a few basis points up to over 10 basis
points. Time intervals longer than the 6M period used in fig. 4.1 further increase the
effect. Notice that positive correlation implies negative adjustment, thus lowering the
forward rates that enters the pricing formulas above.
The standard market practice for pricing interest rate derivatives does not consider
the quanto adjustment, thus leaving, in principle, the door open to arbitrage oppor-
tunities. In practice the adjustment depends on variables presently not quoted on the
market, making virtually impossible to set up arbitrage positions to lock today positive
gains in the future. Obviously, it is always possible to bet on a view of the future
realizations of the volatilties and correlation.

4.2. Hedging
We come now to the problem of hedging. We assume to have a trading portfolio filled
with a variety of interest rate derivatives with different underlying rate tenors. The first
issue is how to calculate the delta sensitivity. In principle, the answer is straightforward:
having recognized interest-rates with differentn tenors as different
o underlyings, and hav-
ing constructed multiple yield curves { = {d , {f , ..., {f
I1 IN
using homogeneous market
instruments, we must coherently calculate the delta with respect to the market rate of
each bootstrapping instrument8 . In practice this can be computationally cumbersome,
given the higher number of market instruments involved.
Once the delta sensitivity is known for each pillar of each relevant curve, the next
issues of hedging are the choice of the set of hedging instruments and the calculation
8
with the obvious caveat of avoiding double counting of those instruments eventually appearing in
more than one curve (3M Futures for instance could appear both in {d and in {If3M curves).

21
of the corresponding hedge ratios. In principle, there are two alternatives: a) the set
of hedging instruments overlaps exactly the set of bootstrapping instruments; or, b) it
is a subset restricted to the most liquid bootstrapping instruments. The first choice
allows for a straightforward calculation of hedge ratios and representation of the delta
risk distribution of the portfolio. But, in practice, people prefer to hedge using the most
liquid instruments, both for better confidence in their market prices and for reducing
the cost of hedging. Hence the second strategy generally prevails. In this case the
calculation of hedge ratios requires a three-step procedure: first, the delta is calculated
on the basis of all bootstrapping instruments; second, it is re-aggregated, pillar by pillar,
on the basis of hedging instruments, using the appropriate mapping rules; then, hedge
ratios are calculated. The disadvantage of this second choice is, clearly, that some risk -
the basis risk in particular - is only partially hedged: hence, a particular care is required
in the choice of the hedging instruments.
A final issue regards portfolio management. In principle one could keep all the inter-
est rate derivatives together in a single portfolio, pricing each one with its appropriate
forwarding curve, discounting all cashflows with the same discounting curve, and hedg-
ing using the preferred choice described above. A possible alternative is the segregation
of homogeneous contracts (with the same underlying interest rate index) into dedicated
sub-portfolios, each managed with its appropriate curves and hedging tecniques. The
eventually remaining non-homogeneous instruments (those not separable in pieces de-
pending on a single underlying) can be redistributed in the portfolios above according
to their prevailing underlying (if any), or put in other isolated portfolios, to be handled
with special care. The main advantage of this second approach is to “clean up” the
trading books, “cornering” the more complex deals in a controlled way, and to allow
a clearer and self-consistent representation of the sensitivities to the different underly-
ings, and in particular of the basis risk of each sub-portfolio, thus allowing for a cleaner
hedging.

5. Conclusions

We have discussed how the liquidity crisis and the resulting changes in the market quota-
tions, in particular the very high basis swap spreads, have forced the market practice to
evolve the standard procedure adopted for pricing and hedging single-currency interest
rate derivatives. The new double-curve paradigm involves the bootstrapping of multi-
ple yield curves using separated sets of vanilla interest rate instruments homogeneous in
the underlying rate (typically with 1M, 3M, 6M, 12M tenors). Prices, sensitivities and
hedge ratios of interest rate derivatives on a given underlying rate tenor are calculated
using the corresponding forward curve with the same tenor, plus a second distinct curve
for discount factors.
We have shown that the old, well-known, standard single-curve no arbitrage relations

22
are no longer valid and can be recovered with the introduction of a (forward) basis
adjustment, for which simple statical expressions are given in eqs. 2.17-2.18 in terms of
discount factors from the two curves. Our numerical results have shown that the basis
adjustment curves, in particular in a realistic stressed market situation, may display an
oscillating term structure, not present in the smooth and monotonic basis swaps market
quotes and more complex than that of the discount and forward curves. Such richer
micro-term structure is caused by amplification effects of small local differences between
the discount and forwarding curves and constitutes both a very sensitive test of the
quality of the bootstrapping procedure (interpolation in particular), and an indicator of
the tiny, but observable, differences between different interest rate market areas. Both
of these causes may have appreciable effects on the price of interest rate instruments, in
particular when one switches from the single-curve towards the double-curve framework.
Recurring to the foreign-currency analogy we have also been able to recompute the
no arbitrage double-curve-single-currency market-like pricing formulas for basic interest
rate derivatives, zero coupon bonds, FRA, swaps caps/floors and swaptions in particular.
Such prices depend on forward or swap rates on curve {f corrected with the well-
known quanto adjustment typical of cross-currency derivatives, naturally arising from
the change between the numeraires, or probability measures, naturally associated to the
two yield curves. The quanto adjustment depends on the volatility σ f of the forward
rates Ff on {f , of the volatility σ X of the forward exchange rate Xf d between {f and {d ,
and of the correlation ρf X between Ff and Xf d . In particular, a non-trivial adjustment
is obtained if and only if the forward exchange rates Xf d are stochastic (σ X 6= 0) and
correlated to the forward rate Ff (ρf X 6= 0). Analogous considerations hold for the
swap rate quanto adjustment. Numerical scenarios show that the quanto adjustment
can be non negligible for realistic values of volatilities and correlation. The standard
market practice does not take into account the adjustment, thus being, in principle, not
arbitrage free, but, in practice the market does not trade enough instruments to set up
arbitrage positions. Hence only bets are possible on the future realizations of voloatility
and correlation.

References

[1] P. S. Hagan, G. West, “Methods for Constructing a Yield Curve”, Wilmott Maga-
zine, p 70-81, May 2008.

[2] P. S. Hagan, G. West, “Interpolation Methods for Curve Construction”, Applied

Mathematical Finance, Vol. 13, No. 2, 89—129, June 2006.

[3] L. Andersen, “Discount Curve Construction with Tension Splines”, Review of

Derivatives Research, Springer, vol. 10, issue 3, pages 227-267, Dec. 2007.

23
 [4] U. Ron, “A Practical Guide to Swap Curve Construction”, Working Paper 2000-17,
Bank of Canada, Aug. 2000.

[5] P. Madigan, “Libor Under Attack”, Risk Magazine, Jun. 2008,

http://www.risk.net/public/showPage.html?page=797090.

[6] F. Ametrano, M. Bianchetti, “Smooth Yield Curves Bootstrapping For Forward

Libor Rate Estimation and Pricing Interest Rate Derivatives”, to be published in
“Modelling Interest Rates: Latest Advances for Derivatives Pricing”, edited by F.
Mercurio, Risk Books.

[7] E. Fruchard, C. Zammouri, E. Willems, “Basis for change”, Risk, 8(10), 70—75,
1995.

[8] B. Tuckman, P. Porfirio, “Interest Rate Parity, Money Market Basis Swaps, and
Cross-Currency Basis Swaps”, Fixed Income Liquid Markets Research, Lehman
Brothers, Jun 2003.

[9] W. Boenkost, W. Schmidt, “Cross currency swap valuation”, Working Paper, HfB—
Business School of Finance & Management, May 6, 2005, http://www.frankfurt-
school.de/dms/publications-cqf/CPQF_Arbeits2.pdf.

[10] M. Kijima, K. Tanaka, T. Wong, “A Multi-Quality Model of Interest Rates”, Quan-

titative Finance, 2008.

[11] M. Morini, “Credit Modelling After the Subprime Crisis”, Marcus Evans course,
2008.

[12] F. Mercurio, “Post Credit Crunch Interest Rates: Formulas and Market Models”,
working paper, Bloomberg, 2008, http://ssrn.com/abstract=1332205.

[13] D. Brigo, F. Mercurio, “Interest Rate Models - Theory and Practice”, 2nd edition,
Springer 2006.

[14] QuantLib is an open-source object oriented C++ financial library

(http://www.quantilib.org).

[15] F. Jamshidian, “An Exact Bond Option Formula”, Journal of Finance, 44, pp.
205-209, 1989.

[16] H. Geman, N. El Karoui, J.C.Rochet, “Changes of Numeraire, Changes of Prob-

ability Measure and Option Pricing”, J. of Applied Probability, Vol. 32, n. 2, pp.
443-458, 1995.

24
Figure 1.1: Quotations as of 30 Sep. 2008 for five basis swap curves corresponding to
the four Euribor swap curves 1M, 3M, 6M, 12M (source: Reuters, contributor: ICAP).

25
 110 EUR Basis swaps
3M vs 6M
100 1M vs 3M
1M vs 6M
90
6M vs 12M
80 3M vs 12M
1M vs 12M
basis spread (bps)

70

60

50

40

30

20

10

0
1Y

2Y

3Y

4Y

5Y

6Y

7Y

8Y

9Y

10Y

11Y

12Y

15Y

20Y

25Y

30Y

Figure 1.2: Euribor basis swap spreads (basis points) versus swap maturity (years) from
Fig. 1.1. The curve 1M-12M has been deduced from the quoted 3M-12M and 1M-3M
curves.

26
 5.00% 6M curve
4.75%

4.50%
forward rate (%)

4.25%

4.00%

3.75%

3.50%
3.25%

3.00%
09/2008

09/2011

09/2014

09/2017

09/2020

09/2023

09/2026

09/2029

09/2032

09/2035

09/2038

09/2041

09/2044

09/2047

09/2050

09/2053

09/2056

09/2059

09/2062

09/2065
5.00% Discount curve
4.75%

4.50%
forward rate (%)

4.25%

4.00%

3.75%
3.50%

3.25%

3.00%
09/2008

09/2011

09/2014

09/2017

09/2020

09/2023

09/2026

09/2029

09/2032

09/2035

09/2038

09/2041

09/2044

09/2047

09/2050

09/2053

09/2056

09/2059

09/2062

09/2065

Figure 2.1: Forward curves, plotted with 6M-tenor forward rates

F (t0 ; t, t + 6M, act/360 ), t daily sampled and t0 = 15 Sep. 2008. Upper panel:
forward curve from 6M curve {If6M ; lower panel: forward curve from discount curve {d
(see description in the text). The effects of the market stress are clearly visible in the
crazy roller-coaster look-up of the curves. The same pattern is observed also in the
1M, 3M, 12M curves (not reported here).

27
 1.15 Basis adjustment (multiplicative) 1.03 Basis adjustment (multiplicative)

1.10
1.02
1.05

basis adjustment
1.01
basis adjustment

1.00

0.95 1.00

0.90
0.99
0.85 1M vs Disc 1M vs Disc
3M vs Disc 3M vs Disc
6M vs Disc 0.98 6M vs Disc
0.80 12M vs Disc 12M vs Disc

0.75 0.97
Mar-09

Mar-10

Mar-11
Dec-08

Jun-09

Dec-09

Jun-10

Dec-10

Jun-11
Sep-08

Sep-09

Sep-10

Sep-11

Sep-14

Sep-17

Sep-20

Sep-23

Sep-26

Sep-29

Sep-32

Sep-35

Sep-38

Sep-41

Sep-44

Sep-47
Sep-11

120 Basis adjustment (additive) 15 Basis adjustment (additive) 1M vs Disc

3M vs Disc
100 6M vs Disc
10 12M vs Disc
80 1M vs Disc
3M vs Disc
basis spread (bps)

basis spread (bps)

60 6M vs Disc 5
12M vs Disc
40
0
20

0 -5

-20
-10
-40

-60 -15
Mar-09

Mar-10

Mar-11
Jun-09

Jun-10

Jun-11
Sep-08

Dec-08

Sep-09

Dec-09

Sep-10

Dec-10

Sep-11

Sep-14

Sep-17

Sep-20

Sep-23

Sep-26

Sep-29

Sep-32

Sep-35

Sep-38

Sep-41

Sep-44

Sep-47
Sep-11

Figure 2.2: Upper panels: multiplicative basis adjustments from eq. 2.17 as of 15 Sep.
2008 (end of day), for daily sampled 6M-tenor forward rates as in fig. 2.1, calculated
on {If1M , {If3M , {If6M and {If12M curves against {d taken as reference curve. Lower panels:
equivalent plots of the additive basis adjustment of eq. 2.18 between the same forward
rates (basis points). Left panels: 0Y-3Y data; Right panels: 3Y-40Y data on magnified
scales. The higher short-term adjustments seen in the left panels are due to the higher
short-term market basis spread (see Figs. 1.1-1.2). The oscillating term structure
observed is due to the amplification of small differences in the term structures of the
curves.

28
 25 Basis adjustment (additive) 1M vs Disc
3M vs Disc
20 6M vs Disc
12M vs Disc
15
basis spread (bps)

10
5
0
-5
-10
-15
-20
-25
Sep-08

Sep-10

Sep-12

Sep-14

Sep-16

Sep-18

Sep-20

Sep-22

Sep-24

Sep-26

Sep-28

Sep-30

Sep-32

Sep-34

Sep-36

Sep-38

Sep-40

Sep-42

Sep-44

Sep-46

Sep-48
5.00% Forward curve 6M
4.75%

4.50%
forward rate (%)

4.25%

4.00%

3.75%

3.50%

3.25%

3.00%
09/2008

09/2011

09/2014

09/2017

09/2020

09/2023

09/2026

09/2029

09/2032

09/2035

09/2038

09/2041

09/2044

09/2047

09/2050

09/2053

09/2056

09/2059

09/2062

09/2065

Figure 2.3: Same as in figs. 2.1 and 2.2, but with linear interpolation on zero rates (a
common market practice). The angular points in the lower panel clearly show the inade-
quacy of the boostrap, but the very strong oscillations in the (additive) basis adjustment
in the upper panel (notice the different scales w.r.t. fig. 2.2, lower panels) allows to fur-
ther appreciate the innatural differences induced in similar forward instruments priced
on the two curves.

29
Figure 3.1: Picture of no-arbitrage interpretation for the forward exchange rate in eq.
3.2. Moving, in the yield curve vs time plane, from top right to bottom left corner
through path A or path B must be equivalent. Alternatively, we may think to no-
arbitrage as a sort of zero “circuitation”, sum of all trading events following a closed
path starting and stopping at the same point in the plane. This description is equivalent
to the traditional “table of transaction” picture, as found e.g. in fig. 1 of ref. [8].

30
 1.04 Quanto Adjustment (multiplicative)
1.03

1.02
Quanto adj.

1.01

1.00

0.99

0.98 Sigma_f = 20%, Sigma_X = 5%

Sigma_f = 30%, Sigma_X = 10%
0.97 Sigma_f = 40%, Sigma_X = 20%
0.96
-1.0 -0.8 -0.6 -0.4 -0.2 -0.0 0.2 0.4 0.6 0.8 1.0
Correlation

20 Quanto Adjustment (additive)

15

10
Quanto adj. (bps)

-5

-10 Sigma_f = 20%, Sigma_X = 5%

Sigma_f = 30%, Sigma_X = 10%
-15
Sigma_f = 40%, Sigma_X = 20%
-20
-1.0 -0.8 -0.6 -0.4 -0.2 -0.0 0.2 0.4 0.6 0.8 1.0
Correlation

Figure 4.1: Numerical scenarios for the quanto adjustment. Upper panel: multiplicative
(from eq. 3.14); lower panel: additive (from eq. 3.16). In each figure we show the quanto
adjustment corresponding to three different combinations of (flat) volatility values as a
function of the correlation. The time interval is fixed to T1 − t = 0.5 and the forward
rate entering eq. 3.16 to 4%, a typical value in fig. 2.1. We see that, for realistic
values of volatilities and correlation, the magnitudo of the additive adjustment may be
important.
31