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Interest Rates After the Credit Crunch: Markets and Models Evolution

Author

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  • Bianchetti, Marco

    () (Intesa Sanpaolo)

  • Carlicchi, Mattia

    () (Intesa Sanpaolo)

Abstract

We present a quantitative study of the evolution of markets and models during the recent crisis. In particular, we focus on the fixed income market and we analyze the most relevant empirical evidence regarding the divergence between Libor and OIS rates, the explosion of basis swaps spreads, and the diffusion of collateral agreements and CSA-discounting, in terms of credit and liquidity effects. We also review the new modern pricing approach prevailing among practitioners, based on multiple yield curves reflecting the different credit and liquidity risk of Libor rates with different tenors and the overnight discounting of cash flows originated by derivative transactions under collateral with daily margination. We report the classical and modern no-arbitrage pricing formulas for plain vanilla interest rate derivatives, and the multiple-curve generalization of the market standard SABR model with stochastic volatility. We then report the results of an empirical analysis on recent market data comparing pre- and post-credit crunch pricing methodologies and showing the transition of the market practice from the classical to the modern framework. In particular, we prove that the market of interest rate swaps has abandoned, since March 2010, the classical single-curve pricing approach, typical of the pre-credit crunch interest rate world, and has adopted the modern multiple-curve CSA approach, thus incorporating credit and liquidity effects into market prices. The same analysis is applied to European caps/floors, finding that the full transition to the modern multiple-curve CSA approach has been deferred until August 2010. Finally, we show the robustness of the SABR model to calibrate the market volatility smile coherently with the new market evidences.

Suggested Citation

  • Bianchetti, Marco & Carlicchi, Mattia, 2011. "Interest Rates After the Credit Crunch: Markets and Models Evolution," Journal of Financial Transformation, Capco Institute, vol. 32, pages 35-48.
  • Handle: RePEc:ris:jofitr:1459
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    Cited by:

    1. Leippold, Markus & Strømberg, Jacob, 2014. "Time-changed Lévy LIBOR market model: Pricing and joint estimation of the cap surface and swaption cube," Journal of Financial Economics, Elsevier, vol. 111(1), pages 224-250.

    More about this item

    Keywords

    crisis; liquidity; credit; counterparty; risk; fixed income; Libor; Euribor; Eonia; yield curve; forward curve; discount curve; single curve; multiple curve; volatility surface; collateral; CSA discounting; no arbitrage; pricing; interest rate derivative;

    JEL classification:

    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing

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