Multi Curves
Multi Curves
Multi Curves
Michael Nealon
SFMW Talk
Outline
Introduction
o Curve Construction
o Black-Scholes
4.00
3.00
6M Depo
3M Depo & 3x6s FRA
2.00
6x1s
6M OIS
1.00
0.00
1/01/2007 1/01/2008 31/12/2008 31/12/2009
In light of this, the market has modified the treatment of derivatives, in terms of
o Pricing
o Revaluation
o Liquidation
o Collateralisation
Arbitrage opportunities?
3x6s trading strategy
Buy 6M Bill Sell 3M Bill Sell 2nd 3M Bill Pay Fixed 3x6s FRA Nett C/F
Today -1 1 0
3M
6M 0
But this no longer holds: Will this strategy really produce a risk-free profit?
Arbitrage opportunities?
No! It assumes:
All cash flows are free of default risk, and
We can always borrow at Libor FLAT in 3 months time
Historically, these issues have been considered insignificant for inter-bank lending
As a result, banks could mismatch the term of their assets and liabilities
Lend long-term to customers, and
Fund with (cheap1) short-term inter-bank lending
The credit-crunch changed the market’s perceptions, and banks are now more conservative about
Default of other banks
Their own future cost-of-funds (the rate at which they can borrow)
These risk are being priced into
Money Market lending rates (eg. Libor/BBSW)
Derivatives written on these rates
1
As compared to long-term committed funding from capital markets (ie. bonds and FRNs)
Credit versus Liquidity
Most agree the spreads are a combination of credit and liquidity issues
Liquidity is used to mean:
Funding Liquidity: Ability to pay liabilities when they are due
Asset Liquidity: Ability to sell an asset within a required timeframe
Systemic Liquidity: Ability to borrow funds (at any cost)
Difficult to disentangle liquidity from credit
Distressed entities suffer from funding illiquidity (increasing the risk of default)
During a crisis:
o Investment contracts and migrates to safer (eg. shorter-term) opportunities
o Funding becomes more expensive (due to lost supply as well as credit concerns)
Both Mercurio (2009) and Morini (2008 & 2009) investigated the efficacy of a default-only model to
explain the spreads
Each use risky generic inter-bank counterparties, and attempt to calibrate to market rates
Simple default-only models can explain the spread between secured and unsecured lending
o ie. Libor vs OIS
But basis spreads (ie. Libor vs Libor) require a more complicated model
Default-Only Model
Morini (2009) models the risk that a counterparty may not remain a Libor-bank to maturity
Consider an investor wanting to lend funds to a Libor-bank for 1 year, with two choices:
1. Committed (unsecured) funding for 12 months
2. Rolling funding (say, semi-annually)
Approach (2) has an embedded option as the investor can change borrower mid-stream
In particular, if the initial borrower’s cost-of-funds exceed some threshold
With Approach (1): The investor can also unwind but only at prevailing market rates and subject to liquidity
35 35
1Y
30 16/07/2008 30
10Y
25 2/02/2009 25
20 20/05/2010 20
15 15
10 10
5 5
0
0
0 5 10 15 20 25 30
Maturity (Years) 3/01/2007 3/01/2008 2/01/2009 2/01/2010
Supply-Demand Dynamics
There are natural buyers and sellers of basis in the market
Corporate lending: Often customers require monthly repayments while inter-bank swaps are
quarterly and semi-annual (and so banks accumulate 6x1s and 3x1s basis risk)
EUR Public Sector finance: Asset swaps pay Euribor3M, while inter-bank swaps are Euribor6M
Previously many institutions held on to this risk (spreads were small and the perceived risk minimal)
In fact, when basis spreads widened many institutions immediately made (unrealised) profits from
their existing positions
Banks are now managing their basis positions more closely, due to
A realisation that spreads now have volatility (up and down) and so exposure needs to be managed
Newly imposed risk oversight
Price discovery occurs as various participates act to neutralise their basis positions
In the same way as banks have always manage fixed and floating interest exposure
Of course, this is also moderated by the market’s perception of the future Spot Basis
Changes to collateralised trades
Collateral agreements (typically via the ISDA Credit Support Annex) provide credit-risk mitigation for
derivative trades
1. Cpty A and Cpty B enter into
Counterparty Counterparty
(1) collateralised trade
A B
2. The trade becomes NPV negative for
Cpty A, and posts collateral (Margin Call)
(2)
3. Cpty B pays Cpty A interest on the
collateral (at the O/N cash rate)
(3)
Opening Balance(T) = Closing Balance(T-1) x (1 + Overnight Rate / 365)
4. If Cpty A defaults, Cpty B takes
ownership of the collateral
Margin Call(T) = Trade MTM(T) – Opening Balance(T)
where
is the forward rate from the -forward rate projection curve (defined by ) and
The portfolio is managed such that it replicates the value of the derivative (ie. )
The standard assumption is that the cash position accrues interest at the risk-free rate , that is
Standard derivative pricing
By applying Ito’s Lemma, equating terms and setting , we get the standard Black-Scholes PDE
A few more straightforward steps (including another application of Ito’s Lemma) produces
and the derivative’s value can be expressed (via Ito’s Lemma) as both
and
where is the expectation under the forward measure defined by the numeraire
where is the expectation under the risky forward measure defined by the numeraire
Forward prices and convexity
Consider a forward contract with forward price (ie. )
Depending on whether or not collateral is posted the value of the contract is either
or
But the market only quotes one set of forward prices (generally based on collateralised trading)
where
so
Note: is a martingale under the -forward measure (by the tower property of expectations)
FRA Pricing
Standard-market FRA contracts settle in-advance according to one of two conventions:
and
Mercurio (2010) derives an approximation for the correction (assuming shifted-lognormal processes)
He argues that under “reasonable” conditions the convexity is small, even for long maturities
Caplet Pricing
Consider a caplet on -Libor with pay-off
But as is martingale under this measure, we can assume its dynamics to be of the form
where is a Brownian motion under forward measure, which leads to (using the standard approach)
So we can price the caplet as per usual except the forward rate is taken from the projection curve and
discount factor is taken from the discount curve.
But from where do we find ?
We have market observable Caps/Floors for 3M
What about 1M or 6M?
Standard volatility conversion algorithms assume single-curve dynamics
Swaption pricing
Now consider a payer swaption paying at time
where
The value of the swaption under the swap measure (defined by the numeraire ) is
where is a martingale.
In his model:
The martingales are independent of the discounting forwards
o So that spreads are martingales under all forward and swap measures
is correlated with to capture cross-basis relationships
o But this does not guarantee: for all and
He also derives formulae for Cap/Floor and Swaptions under these models
Facilitating the pricing of options on non-standards tenors
How should all these parameters (volatilities and correlations) be calibrated?
Mercurio (2010) suggests using additional degrees of freedom to fit:
o The Cap/Floor smile, and/or
o CMS spreads
Still need to calibrate volatility and correlation of non-standard tenors (eg. = 1M or 6M)
Derivative pricing with and without collateral
So in summary the approach to pricing and revaluation is:
Trades fully collateralised with cash: (eg. standard inter-bank swaps and options)
o Discount with OIS curve
o Forecast with basis-specific curves (bootstrapped with OIS curve for discounting)
o First Order: Correct moneyness using basis-specific curves (static-basis model)
o [H] Second Order: Correct volatility (model spread dynamics)
o [H] Apply a convexity adjustment to In-advance instruments
Unsecured Trades: (eg. trades with non-bank customers, notes and hedges with exotic coupons)
o As above except,
o Discount with a treasury (cost-of-funds) curve
o [H] Apply a convexity adjustment to forwards for the miss-matched numeraire
o [H] Apply CVA (adjusting for counterparty default risk)
Burgard & Kjar (2010) and Fries (2010) look at credit and funding simultaneously
Partially secured Trades: (eg. trades with non-cash collateral, or thresholds on margining)
o As above except,
o [H] Discount with repo curve appropriate to collateral type (eg. Bond Repo rates)
o [H] Apply CVA (simulating collateralisation rules, eg Assefa et al 2009)
Burgard, Kjar (2010) “PDE representations of options with bilateral counterparty risk and funding costs”
Fries (2010) “Discounting Revisited. Valuations under Funding Costs, Counterparty Risk and
Collateralization”
Mercurio (2009) “Interest Rates and The Credit Crunch: New Formulas and Market Models”, Bloomberg
Portfolio Research Paper No.2010-01-FRONTIERS
Mercurio (2010) “LIBOR Market Models with Stochastic Basis”, OTC Derivatives and Structured Notes
Bloomberg LP
Morini (2008) “The limits of existing models for correlation, rates and credit. Lessons from the crisis”,
Banca IMI
Morini (2009) “Solving the puzzle in the Interest Rate Market”, Banca IMI
Piterbarg (2010) “Funding beyond discounting: collateral agreements and derivative pricing”, Risk
February
Whittall (2010a) “The price is wrong”, Risk March
Whittall (2010b) “LCH.Clearnet considers revaling $212trillion swap portfolio”, Risk April
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