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

25 Pages Posted: 8 Dec 2009  

Masaaki Fujii

University of Tokyo - Faculty of Economics

Yasufumi Shimada

Shinsei Bank, Ltd

Akihiko Takahashi

University of Tokyo - Faculty of Economics

Date Written: November 12, 2009

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.

Keywords: Market Model, HJM model, Libor, tenor, swap, curve, OIS, cross currency, basis spread, interest rate model, derivatives, multi-currency

Suggested Citation

Fujii, Masaaki and Shimada, Yasufumi and Takahashi, Akihiko, A Market Model of Interest Rates with Dynamic Basis Spreads in the Presence of Collateral and Multiple Currencies (November 12, 2009). Available at SSRN: https://ssrn.com/abstract=1520618 or http://dx.doi.org/10.2139/ssrn.1520618

Masaaki Fujii

University of Tokyo - Faculty of Economics ( email )

7-3-1 Hongo, Bunkyo-ku
Tokyo 113-0033
Japan

Yasufumi Shimada

Shinsei Bank, Ltd ( email )

Chiyoda, Tokyo
Japan

Akihiko Takahashi (Contact Author)

University of Tokyo - Faculty of Economics ( email )

7-3-1 Hongo, Bunkyo-ku
Tokyo 113-0033
Japan

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