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AGE-OLD CUSTOMS IN THE NEW AGE

From Single to Multi-Curve Adapting to Change

Ethan Reiner, Head of Quantitative Research – Investment Solutions, AXA Investment Managers

A lively debate has been raging in the quantitative ﬁnance community since the burst of the credit bubble in 2007. The burning issue involves what was, at least on the surface, one of the simplest problems in the ﬁeld: how to price an interest rate swap. The question is intimately linked to the construction of a risk-free yield curve, the cornerstone of ﬁnance. Swaps had become standardised and liquid over the past 30 years and their quotes are overwhelmingly used by banks and asset managers to track the interest rate market and to build yield curves. Up until the crisis, simple no-arbitrage arguments had allowed us to simply extract both discount rates and expected forward rates from swap quotes. The hypotheses leading to the no-arbitrage derivation of swap prices have proved faulty. As a result, academics and practitioners are faced with the challenge of expanding interest rate theory to accommodate recent events. In a nutshell, the working assumption in the past was that Libor (or Euribor), the underlying index used for the ﬂoating payments of swaps, was a risk-free rate. Although this assumption was known to be wrong, it was accepted as standard fare. The dramatic string of major bank failures in 2007 culminating with the Lehman Brothers debacle in 2008, demonstrates just how uncertain Libor really is. Some banks that were once Libor contributors are no longer in the panel while others have disappeared. This article is a survey of the main issues surrounding the construction of a theoretically consistent system of interest rate curves in the post-crisis era. We will see that we can no longer model forward Libor rates and risk-free discount rates with a single yield curve.

5

A new multiple curve theory has emerged in the last four years that is meant to provide separate estimates for risk-free rates and forward rates. Pre-crisis academic articles dealing with risky Libor (see CollinDufresne and Solnik1) abound, however their findings were not embraced by most practitioners as spreads were not significant enough to exploit. Although multiple-curve solutions have been used for a number of years in cross currency markets (see Tuckman and Homé2), Bianchetti3 was one of the first public articles to discuss a multi-curve solution in the single currency context. Mercurio4 discusses the impact of multi-curves on vanilla derivatives such as swaptions and caps. In addition, he considers a modification of the Libor Market Model that integrates a dynamic spread. An original approach is proposed by Morini , where an attempt is made to explain recent data by modeling the optionality underlying the Libor index. The main objective of this article is to highlight the reasons for the emergence of a new theory and to present the technical aspects of the multi-curve algorithm. We will conclude with some comments on dynamic extensions of the approach as well as on the impacts on trading and booking systems in financial institutions.

5

Graph 1: The forward rate replication stategy

perception of forward Libor rates is at the heart of swap valuation, we take as our point of departure the classic derivation of the fair forward rate. We review the textbook approach for determining the forward rate and examine the hypotheses which failed starting August 2007. We assume a deposit market in which banks may borrow and lend without default risk or liquidity costs. In our simple example we show how Bank A can lock-in a borrowing (lending) rate over a future period and . Then we can show that the arbitrage free forward rate for the future time interval is . Let be the deposit rate for the period the deposit rate for the period

borrowing the rate an outflow of at

over the period : an inflow of at

at and

. In fact, this replication strategy

shows that this is the unique fair rate as seen at time 0: If Bank B were to offer a lower lending rate then Bank A could turn this into a profit by borrowing at the forward rate offered by Bank B and selling the above replication strategy. This ensures a profit for Bank A of at time with no initial cost at time 0.

If we relax default and liquidity assumptions we immediately realise that the above strategy is not risk-free. Default of the deposit will cause Bank A to suffer a loss; if there is a liquidity squeeze then bid-ask spreads widen and the initial zero cost assumption for setting up the strategy breaks down. These potentially catastrophic effects for the arbitrage

**The End of the Libor Discounting Paradigm
**

To get a clear understanding of the profound changes that have affected interest rate markets since August 2007, it is worthwhile to step back and have a look at pre-crisis working assumptions. The risk-free curve was extracted from deposits, futures and swap rates. A swap is a bilateral agreement to exchange a floating Libor rate against a known fixed rate over the life of the swap. Since the Indeed, if the bank wants to ensure it can borrow at this rate for a notional of Euros it can set up a simple strategy: Borrow until at the rate until and immediately lend this amount at . Graph 1 illustrates the cash flows of the strategy. It easy to see that the net flows correspond exactly to the flows of

strategy are not new to market players; however, they were all but ignored for the construction of forward rates. Strong evidence that something had gone awry started to surface in August 2007, when practitioners remarked an unusual divergence between short maturity overnight index swap rates and same

**Graph 2: Historic 3M Euribor and 3M overnight index swap quotes for the period 2000-2011
**

6% 5% 4% 3% 2% 1% 0%

08/05/00 08/05/01 08/05/02 08/05/03 08/05/04 08/05/05 08/05/06 08/05/07 08/05/08 08/05/09 08/05/10 08/05/11

rates, if we were to assume no default risk, then we could prove that a large divergence between the overnight index swap and the Euribor rate should lead to an arbitrage opportunity. This was probably the assumption prior to the burst of the credit bubble, on average the spread between the two rates over the period 2000 to 2007 was 6 basis points with a standard deviation of 2 basis points. Over the period August 2007 to September 2011 the average spread was 55 basis points with a standard deviation of 35 basis points. Similar results are found when we compare these same instruments at different maturities such as 1M, 6M or 12M. Graph 3 shows the evolution of the spread over the period 2000-2011 and highlights the impressive increase over the period starting 2007-2011. Graph 4 illustrates the spread distribution and provides compelling

3M Overnight Index Swap 3M Euribor

Source: Bloomberg

Graph 3: Historic spread between 3M Euribor and 3M overnight index swap quotes for the period 2000-2011

2,0%

**1,5% Lehman aftermath 1,0% Sovereign debt crisis 0,5% Burst of the credit bubble 0,0%
**

08/05/00 08/05/01 08/05/02 08/05/03 08/05/04 08/05/05 08/05/06 08/05/07 08/05/08 08/05/09 08/05/10 08/05/11

evidence that a true change of regime has occurred. This dramatic shift was not well understood at first. However, it is now largely admitted that this spread represents a major risk that is now being priced by markets. One can no longer ignore the impact of credit risk on interest rates... not even when we consider the very fundamental object which is the yield curve.

Source: Bloomberg

maturity deposit rates. Graph 2 displays this phenomenon for three-month maturity instruments. To better understand what is at stake in this graph we recall the definition of the two rates under consideration:

■ ■

sample of prime banks belonging to the European Banking Federation. The 3m Overnight Index Swap is the fixed rate that counterparties are willing to pay in three months against the daily compounded overnight rate over the same period. It is important to note that the overnight index swap is a collateralised instrument that bears essentially no credit risk. Going back to our basic example of forward

It is now clear that the upshot of recent debates can be simply stated: Libor no longer represents a risk-free rate. Strictly speaking, Libor never was a risk-free rate. However, prior to the credit crisis the difference between Libor rates and riskfree rates of comparable maturities was negligible. This is no longer the case: we now observe a persistent spread between Overnight Index Swaps rates and Libor rates of the same maturity. Markets have

The 3m Euribor index is a daily average of bank offered rates for three-month unsecured lending. The contributing panel of banks is said to be a representative

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To make things clear we require some notation:

example). Since overnight index swaps play a central role in this model, it is also known as the OIS discounting model. The rest of this article focuses on the technical aspects of this new approach.

**Bootstrapping before and after the credit crunch
**

The popular term bootstrap calibration refers had to rethink and adapt previous models in order to account for this new reality. interest rate market as a segmented market in which each partition contains only instruments which reference the same underlying Libor tenor. The credit approach is presented by Mercurio4 and is extended by Morini5 to investigate the dynamics as well as the embedded optionality present in the Libor index. From a theoretical standpoint the credit approach is quite satisfying since it should facilitate the inclusion of previously ignored concepts such as funding and liquidity into rates modeling. This approach is quite involved, however, since Libor does not behave like a classical defaultable counterparty: Libor contains default risk but can never default. Currently, practitioners seem to be leaning towards the segmentation approach in implementing pricing systems as evidenced in a large number of recent articles (see Traven7 for We begin with a general description of the approach and then give a detailed account of how the algorithm works for most major currencies. We will first assume that we are dealing with a market in which a full set of Overnight Indexed Swaps are quoted. This is the case for EUR, GBP JPY and CHF. Next , we will look at some of the concrete details that apply to the EUR market. Discussion of tenor swaps - swaps in which floating rates of different tenors are exchanged - is deferred until the next section, where the

0, 41 0, 28 0, 35 0, 44 0, 25 0, 31 0, 08 0, 01 0, 05 0, 11 0, 15 0, 18 0, 21 0, 38 0, 48 0, 51 0, 54

to an iterative algorithm that extracts a yield curve from a set of interest rate instruments including swap quotes. It enables us to start with an ordered set of quotes for swaps maturing at times and successively obtain discount factors which constitute the key points of the yield curve. In this section we will describe what has changed in the bootstrap procedure in the context of the segmented or multi-curve interest rate model.

**From Libor to Overnight Index-based Discounting
**

The important observations brought up above have led practitioners to seek a robust framework that can account for the following elements when pricing a collateralised interest rate swaps:

■

An interest rate swap involves payments linked to Libor which is a risky unsecured rate;

■

Quoted swap rates refer to collateralised agreements that bear no counterparty risk.

**Two possible approaches come to mind:
**

■

The credit approach: Use a risk-free interest rate for discounting default free cash flows and add an appropriate credit spread to account for risky rates such as future Libor rates;

Strictly speaking Libor never was a risk-free rate. However, prior to the credit crisis the difference between Libor rates and risk-free rates of comparable maturities was negligible. This is no longer the case

■

The segmentation approach: Model the

**Graph 4: Euribor - OIS Distributions 2000-2010
**

900 800 700 Frequency 600 500 400 300 200 100 0

-0 ,0 2

specifics of the USD market are considered.

Graph 5: Overview of the multi-curve method algorithm Interest Rate Market

can be expressed as

**OIS Swaps 3M Swaps 6M Swaps 3M FRAS Deposits Futures
**

Market Segments ON Deposit 3M Deposit 6M Deposit 1D Deposit 3M Futures 3M FRAS 3M FRAS OIS Swaps 3M Swaps 6M Swaps Sequential Bootstrap OIS Discount Curve 3M Libor Projection Curve 6M Libor Projection Curve

This conclusion is reached by showing that the stream of Libor rates on the right hand side of the first equation can be replicated by a rolling Libor deposit strategy whose value at time 0 is given by This is known as the Libor discounting paradigm. When taking into account the possibility of default, the replication strategy is not risk-free. The model makes the following assumptions:

■

.

**Overview of the methodology
**

Our goal is to build an arbitrage-free framework that is adapted to the collateralised interest rate swap market. The approach can be viewed as a straightforward extension of techniques that have been used for years in cross currency markets (see Tuckman for a detailed presentation). The main idea is to split the procedure into two parts: in the first we use a subset of instruments to determine discount factors; we then reuse these discount factors to extract forward rates from other sets of instruments. Graph 5 summarises the multi-curve method. For a given currency we consider a large universe of interest rate instruments covering all the underlying Libor tenors available. The calibration procedure is separated into three broad steps: 1. Partition the instruments according to tenor. 2. Obtain a discount curve using the overnight index segment of the market Although common credit support annex agreements (CSA) provide more flexibility in terms of eligible collateral, our assumption is consistent with broker quotes. Our universe thus consists of futures, forward rate agreements, tenor basis swaps and swaps. Strictly speaking, money market deposits should not be included in the model since they represents uncollateralised instruments. As we explain below, with some care, a subset of deposit rates may be used in the multi-curve system.

■

The key to understanding the multiple curve approach is the observation that the replication argument fails and that the fair swap rate formula is not valid. The risk-neutral value of the Libor leg must be computed as the present value of risky future rates. The expression

The collateral underlying all swaps under consideration is cash in the same currency as the swaps themselves; Swap quotes used in the model refer to bilateral agreements with zero threshold and continuous posting of collateral.

can no longer be simplified: represents risk-free discount factor to be applied to certain payoffs; represent the future risky rates for unsecured loans. The new model must therefore be capable of distinguishing between estimates of risk-free rates used for discounting and unsecured forward rates. Assuming that we have already obtained the risk-free discount factor satisfies , the N-year swap rate with underlying Libor tenor K

Swap Pricing

In the traditional swap valuation approach one shows that by no arbitrage the fair swap rate defined by for The only unknowns in the above equations are the . Equipped with any

.

3. For each segment corresponding to a Libor tenor we obtain projection curve via a bootstrap procedure that uses the previously obtained curve discounting flows.

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9

convenient interpolation assumption we can sequentially extract the . from available swap quotes . It should now be clear that before we can extract Libor rates estimates from swap rates, we must have a risk-free discount curve in hand. We look at this issue in the next section.

Similarly, for futures prices convexity adjustments

we ignore

**The bootstrap calibration proceeds as follows:
**

■

Use OIS quotes bootstrap the discount curve according the standard equation

to

The output of the multi-curve model consists of a discount curve and a set of forward curves. Each forward curve corresponds to market projections concerning a particular tenor: the instruments that contribute to a given forward curve all contain information about the risk of Libor rates of one specific tenor 1M, 3M, 6M, or 12M. Money market deposits seem more difficult to included in our setting since

■ ■ ■

Bootstrap the 6M curve: - Start the curve with the 6M deposits and 6M FRAS - For the swaps use the formula

**The discount curve generated by overnight index swaps
**

Although there may be different methods for obtaining risk-free discount factors, in our approach we will focus on information contained in overnight index (OI) swaps. An OI swap is an agreement to exchange a fixed rate against a floating rate determined by compounding the overnight rate over the reference period. In the overnight case, the rolling strategy still works as long as we make the reasonable the default risk of an overnight loan is negligible. Therefore, if S is a quote for an OIS we can write

They are not collateralised; There is a possible tenor mismatch (each quoted deposit rate refers to a different tenor).

■

Bootstrap the 3M curve: - Start the curve with the 3M deposits, 3M FRAS, and 3M Futures - For the swaps use the formula

We remark, however, that for each forward rate curve corresponding to a Libor tenor K we can view the first deposit rate of appropriate tenor K as directly contributing the first projection point .

**Details of the USD market
**

The USD swap market is substantially different in its quotation convention. The theory presented in the previous sections still applies but some extra work must be done in setting up the bootstrapping procedure. Indeed, the US market has few OIS quotes and beyond 10Y one must use Fed funds swaps in order to extract long term information about overnight rates. We begin by describing the set of available instruments.

**The Euro Curve
**

To make our treatment as concrete The conclusion is that in the presence of an OIS market we can construct a risk-free discounting curve which may be used for discounting cash flows in all cash-collateralised derivatives. Futures, FRAS and deposits Futures and FRAS are collateralised instruments that are priced in the new framework. Indeed, the quoting mechanisms are such that quoted forward rates correspond exactly to the projected Libor rates

OIS Swaps Overnight ON Deposit TN Deposit 1D Deposit 3M 3M Deposit 6M 6M Deposit

as possible we will now consider the details of the multi-curve algorithm for the Euro market. The formulas provided here can be employed in all markets that have a similar structure (GBP JPY and CHF). The Euro market , can be partitioned in the following manner:

OIS Swaps The USD market quotes OIS swaps based on Fed Funds up to 10Y. Leg 1: Fixed Payments - Annual Act/360 Leg 2: Compounded overnight Fed Funds Rate Annual Act/360.

3M FRAs 3M Futures 3M Swaps

6M FRAs 6M Swaps

Fed Fund Swaps The USD market does not quote OIS swaps directly for a number of maturities. The closest liquid proxies are Fed Fund swaps. These have the following description: Variable Leg 1: USD Libor 3M, Act/360 plus spread - Paid quarterly Variable Leg 2: Daily average of the overnight Fed Fund Rate plus spread, Act/360 - Paid quarterly

Fed Funds investment over each of the reference floating rate periods. What distinguishes the USD market from what we have seen so far is the need to combine swap quotes of different types to build synthetic swaps that will enable us to determine risk-free rate. Specifically, we use equilibrium equations from the 3M versus fixed market and the FF versus 3M market: For standard semi-annual vs quarterly:

eliminate all the floating rates and obtain equations in which only discount factors need to be determined. We remark in passing that for actual applications an exact modeling is required in order to properly reconstruct all market instruments. We must therefore be careful in the above equation to distinguish the quarterly year fractions Annual year fractions 30/360 conventions. which use which use the the ACT/360 convention and the Semi-

Standard USD Swaps The standard swaps in the US market are 3M Libor versus fixed rate Variable Leg; USD Libor 3M, Act/360 - Pay Quarterly Fixed Leg: Fixed Rate, 30/360 - Pay SemiAnnually where Tenor Swaps Semi-Annual 6M Libor swaps are not quoted directly. The quoted market consists of tenor swaps. Variable Leg 1: USD Libor 3M, Act/360 Reset Quarterly, Pay Quarterly. Variable Leg 2: USD Libor 6M, Act/360 Reset Semi-Annually, Pay Semi-Annually. Thus, Determining discount rates from USD Fed Fund swaps If we wish to determine OIS from Fed Fund versus 3M swaps we need to make some approximation concerning the average Fed Fund (FF) rate. One possible approach is to assume that the daily compounded rate over the same period gives the same rate: and is the realized average represents the quoted spread Fed Fund rate over the period starting at of the Fed Funds over 3M Libor. By subtracting one equation from the other we get Quarterly vs quarterly tenor swap:

The birth of the multicurve system has been a difﬁcult one. It is not the mere complexity of the model that is troublesome but rather the fact that the yield curve is such a basic object in ﬁnance that it appears everywhere

Bootstrapping 6M USD swaps The approach is similar to the above except that we now assume that discount factors are known and we seek the expected rates. We use the equilibrium equations: For Standard 3M Swaps:

For 3M vs 6M tenor Swaps:

where In the last equation we have used the where is the number of business assumption that the Fed Fund leg can be replicated by rolling a Fed Fund investment over each floating period. The important conclusion here is that we can day over the relevant period. Under this assumption, we can replicate the floating Fed Fund payments by daily rolling of a

represents semi-annual

ACT/360 year fractions. We eliminate the 3M rates to get:

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From Single to Multi-Curve: Adapting to Change

11

Graph 6: Global view of the multi-curve curve building algorithm for USD USD Interest Rate Market

OIS Swaps 3M vs FF Swaps 3M Swaps 3M vs 6M Swaps

**6M FRA 3M FRA Deposits Futures
**

Market Segments Replace Tenor Swaps 3M vs FF Swaps 3M Swaps 3M vs 6 Swaps Virtual 6M Swaps Virtual OIS Swaps Sequential Bootstrap

ON Deposit 3M Deposit 6M Deposit

1D Deposit 3M Futures

OIS Swaps 3M FRAs

6M FRAs

which defines the swaps we can use to solve for the 6M Libor projection curves. Bootstrapping 3M USD Swaps The 3M segment in the US market quotes in a conventional way. Therefore, once we have obtained the discount factors from the first step of the algorithm. We can use swap quotes directly to strip out the 3M projection rates. The full procedure for USD is clearly more involved than for other currencies. Graph 6 gives a schematic overview of the approach.

undesirable effects may occur if we naively extrapolate the bootstrapped rates. A concrete example of what can go wrong can be seen on the USD market where Fed Fund swaps are not liquid beyond 30Y and where at the same time we wish to include long dated 3M versus fix swaps (quoting up to 60Y). We are thus confronted with the difficulty of determining forward Libor rates without any direct market information on risk-free rates beyond 30Y. Extrapolating the risk-free rate in a naive way leads to discounting with a rate higher than the projected 3M Libor rate, which contradicts the assumption that Fed Funds rates are inherently less risky. A first simple solution to such anomalies consists in first extrapolating

Fed Fund spreads over the missing maturities. In this way we maintain a safe distance between 3M forwards and the risk-free rate. This leads to the creation of a set of virtual swaps consistent with quoted spreads up to the last known maturity. These swaps enter the bootstrap mechanism so that the final interpolated/ extrapolated curves are the result of interpolated/extrapolated instruments. The above discussion also pertains to the 3M/6M spread: we suggest interpolating/ extrapolating the spread and then creating the appropriate swaps that are fed into the bootstrap procedure. In Graph 7, we exhibit the interpolation method for the USD case. The left hand panel shows that the 3M projection curve falls below

**Interpolation and Extrapolation
**

Interpolation and extrapolation of the discount curve in the multi-curve context is extremely important. In practice,

**Graph 7: The impact of spread interpolation / extrapolation on the discount curve in the case of USD
**

5,0% 4,5% 4,0% 3,5% 3,0% 2,5% 2,0% 1,5% 1,0% 0,5% 0,0%

0 10 20 30 40 50 60

USD ZC Curves: Naive extrapolation

5,0% 4,5% 4,0% 3,5% 3,0% 2,5%

USD ZC Curves: Spread extrapolation

Discount Curve 3M Fwd Curve

2,0% 1,5% 1,0% 0,5% 0,0%

0 10 20 30 40

Discount Curve 3M Fwd Curve

50

60

Sources: AXA IM, 2011

the discounting curve if we extrapolate the risk-free curve in a naive manner. We recommend the approach used in the right panel where we extrapolate spreads instead.

For more sophisticated products and strategies it is necessary to simulate the full set of curves. Progress in this direction is provided by Mercurio who shows how the standard Libor Market Model can be enriched with a stochastic spread. Pallavicini and Moreni present a generalization of HJM framework and in particular an extension of the popular G2++ short rate model. Despite the slew of recent academic articles attempting to extend the theory, it seems far too early to say which models will be embraced as the most effective and usable. Clearly, much experimentation and research lie ahead before practitioners adopt a new standard model.

6

reader to a recent Risk Magazine article8 where two major banks make a public statement to this effect. Despite the urgency of the matter, however, until recently discrepancies persisted between front office and middle office pricing systems. Starting mid-2011 most major banks seemed to have finally migrated their reporting from Libor to OIS discounting. Banks are now moving to the next challenge in this context which involves accounting for the actual collateral posted for each OTC deal: when the collateral is not cash, the discounting rate has to be appropriately adjusted. On the buy side, integrating these changes is also of great importance. With the number of collateralised transactions on the rise, asset managers are required to provide independent valuations of over-the-counter transactions. Buy side companies tend to be more dependent on third party financial software for financial computations and in particular for yield curve construction. At the time of writing, many of the leading software providers are yet to develop fully integrated multicurve solutions. In the short term, this may lead asset managers dependent on external software to use approximations or other time-consuming short cuts until their usual providers catch up with the changes.

Extensions

The multi-curve system described here is but the first step in a new and exciting direction. The subprime crisis has shaken the world and the foundations of financial economic theory. Derivative pricing theory is in some sense being rewritten as regulation. Collateral agreements and liquidity must be integrated into our working hypotheses in order to obtain more realistic models. At the same time, practitioners require models that are easy to understand and easy to implement. It is yet to be seen whether the new models that will emerge will fit the bill! Focusing on interest rates, there is now a clear need to take the spread between Libor rates and discount rates into account. The graphs shown earlier should convince even the novice that this spread is anything but a constant. It can be shown that in the multi-curve context vanilla products such as caps and swaptions can be priced using Black-Scholes style formulas without directly modeling the spread volatility (see Mercurio ).

4

Impact on Systems

The birth of the multi-curve system has been a difficult one. It is not the mere complexity of the model that is troublesome but rather the fact that the yield curve is such a ubiquitous and fundamental concept in finance. As a result, when a financial institution changes its assumptions and the way it computes discount rates, it can expect side effects and changes in all its accounting and trading books. Banks were the first to be impacted by these changes and as a result they have had to adapt their pricing and booking quickly. On this subject we refer the interested

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13

References

1

Collin-Dufresne, P and Solnik, B. On ., the term structure of default premia in the swap and libor markets. The Journal of Finance LVI, 3 (June 2001). Tuckman, B., and Hom´e, J.-B. Consistent pricing of FX forwards, cross currency basis swaps and interest rate swaps in several currencies. Lehman Brothers Fixed Income Research (December 2003). Bianchetti, M. Two curves, one price: Pricing & hedging interest rate derivatives using different yield curves for dicounting and forwarding. Working Paper (2008). Mercurio, F. Interest rates and the credit crunch: New formulas and market models. Working Paper (February 2009). Morini, M. Solving the Puzzle in the Interest Rate Market. Working Paper (October 2009). Pallavicini, A., and Moreni, N. Parsimonous HJM Modelling for Multiple Yield Curves. Working Paper (2010). Traven, S. Pricing and hedging linear derivatives with an arbitrage-free set of interest rate curve.Barclays Capital Quantitative Credit Quarterly (2010-Q3/Q4). Hallet, N., and Wilson, S. Funding valuation-a clear and present future. Risk Magazine (June2010). RBS and Barclay’s Capital joint sponsored statement.

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Conclusion

In the wake of the economic crisis sparked by the collapse of the sub-prime housing market, many profound changes have impacted derivative trading and pricing. Perhaps the most striking changes involve the contamination of interest rate theory by credit risk. We have reviewed recent events and described the financial phenomena that have led to a new theory for interest rate curve construction. Although most market participants now agree that the credit spread present in Libor is now a fundamental part of interest rate theory, there is still no clear consensus on how to deal with it in practice. Nevertheless, many agree that the multi-curve approach is a consistent and tractable extension of the methods we applied before the credit bubble. Whereas previously, financial institutions had more time to adjust to major theoretical innovations, the shock to interest rate hypotheses seems to have taken everyone by surprise. Due to the pressing demand for collateralised transactions, many practitioners feel rushed to adapt to these changes before the industry as a whole agrees on a new standard for curve construction. In the coming years we expect that these innovations will be absorbed by academia and industry and that some agreed standard models will emerge. Given the fundamental and complex nature of the change we conjecture that this transition will take more time than previous ones.

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Q4 -This document is for informational purposes only and does not constitute, on AXA Investment Managers Paris part, an offer to buy or sell or a solicitation or investment advice. AXA Investment Managers Paris disclaims any and all liability relating to a decision based on or for reliance on this document. Please read the overall disclaimer on page 101 of this document which can be found on www.axa-im.com. AXA INVESTMENT MANAGERS PARIS, a company incorporated under the laws of France, having its registered ofﬁce located at Coeur Défense Tour B La Défense 4, 100, Esplanade du Général de Gaulle 92400 Courbevoie, France.

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