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A Market Model of Interest Rates with Dynamic Basis Spreads in the presence of Collateral and Multiple Currencies

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  • Masaaki Fujii

    (Graduate School of Economics, University of Tokyo)

  • Yasufumi Shimada

    (Capital Markets Division, Shinsei Bank, Limited)

  • Akihiko Takahashi

    (Faculty of Economics, University of Tokyo)

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    Abstract

    The recent financial crisis caused dramatic widening and elevated volatilities among basis spreads in cross currency as well as domestic interest rate markets. Furthermore, the wide spread use of cash collateral, especially in fixed income contracts, has made the effective funding cost of financial institutions for the trades significantly different from the Libor of the corresponding payment currency. Because of these market developments, the text-book style application of a market model of interest rates has now become inappropriate for financial firms; It cannot even reflect the exposures to these basis spreads in pricing, to say nothing of proper delta and vega (or kappa) hedges against their movements. This paper presents a new framework of the market model to address all these issues.

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    File URL: http://www.cirje.e.u-tokyo.ac.jp/research/dp/2009/2009cf698.pdf
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    Bibliographic Info

    Paper provided by CIRJE, Faculty of Economics, University of Tokyo in its series CIRJE F-Series with number CIRJE-F-698.

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    Length: 26pages
    Date of creation: Dec 2009
    Date of revision:
    Handle: RePEc:tky:fseres:2009cf698

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    1. Farshid Jamshidian, 1997. "LIBOR and swap market models and measures (*)," Finance and Stochastics, Springer, vol. 1(4), pages 293-330.
    2. Jarrow, Robert & Yildirim, Yildiray, 2003. "Pricing Treasury Inflation Protected Securities and Related Derivatives using an HJM Model," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 38(02), pages 337-358, June.
    3. Patrick Hagan & Graeme West, 2006. "Interpolation Methods for Curve Construction," Applied Mathematical Finance, Taylor & Francis Journals, vol. 13(2), pages 89-129.
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