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Two Curves, One Price :Pricing & Hedging Interest Rate Derivatives Decoupling Forwarding and Discounting Yield Curves

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  • Bianchetti, Marco

Abstract

We revisit the problem of pricing and hedging plain vanilla single-currency interest rate derivatives using multiple distinct yield curves for market coherent estimation of discount factors and forward rates with dierent underlying rate tenors. Within such double-curve-single-currency framework, adopted by the market after the credit-crunch crisis started in summer 2007, standard single-curve no-arbitrage relations are no longer valid, and can be recovered by taking properly into account the forward basis bootstrapped from market basis swaps. Numerical results show that the resulting forward basis curves may display a richer micro-term structure that may induce appreciable effects on the price of interest rate instruments. By recurring to the foreign-currency analogy we also derive generalised no-arbitrage double-curve market-like formulas for basic plain vanilla interest rate derivatives, FRAs, swaps, caps/floors and swaptions in particular. These expressions include a quanto adjustment 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 unadjusted double-curve prices, in principle, not arbitrage free. Both the forward basis and the quanto adjustment find a natural financial explanation in terms of counterparty risk.

Suggested Citation

  • Bianchetti, Marco, 2008. "Two Curves, One Price :Pricing & Hedging Interest Rate Derivatives Decoupling Forwarding and Discounting Yield Curves," MPRA Paper 22022, University Library of Munich, Germany, revised 24 Jan 2010.
  • Handle: RePEc:pra:mprapa:22022
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    File URL: https://mpra.ub.uni-muenchen.de/22022/1/MPRA_paper_22022.pdf
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    References listed on IDEAS

    as
    1. Uri Ron, 2000. "A Practical Guide to Swap Curve Construction," Staff Working Papers 00-17, Bank of Canada.
    2. Henrard, Marc, 2007. "The irony in the derivatives discounting," MPRA Paper 3115, University Library of Munich, Germany.
    3. Leif Andersen, 2007. "Discount curve construction with tension splines," Review of Derivatives Research, Springer, vol. 10(3), pages 227-267, December.
    4. Patrick Hagan & Graeme West, 2006. "Interpolation Methods for Curve Construction," Applied Mathematical Finance, Taylor & Francis Journals, vol. 13(2), pages 89-129.
    Full references (including those not matched with items on IDEAS)

    More about this item

    Keywords

    liquidity; crisis; counterparty risk; yield curve; forward curve; discount curve; pricing; hedging; interest rate derivatives; FRAs; swaps; basis swaps; caps; floors; swaptions; basis adjustment; quanto adjustment; measure changes; no arbitrage; QuantLib;

    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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