Short-Rate Pricing After the Liquidity and Credit Shocks: Including the Basis

Abstract

The basis between swaps referencing funded fixings and swaps referencing overnight-collateralized fixings (e.g. 6 month Euribor vs 6 month Eonia) has increased in importance with the 2007-9 liquidity and credit crises. This basis means that new pricing models for fixed income staples like caps, floors and swaptions are required. Recently new formulae have been proposed using market models. Here we present equivalent pricing in a short-rate framework which is important for applications involving credit, like CVA, where this is often useful because default can occur at any time. Furthermore, in this new multiple-curve world, short-rate models are fundamentally altered and we describe these changes.

Keywords: Credit Crisis, Liquidity Crisis, Forward Curve, Discount Curve, Basis Swaps, Bootstrapping, Swaps, Swaptions, Counterparty Risk, CVA, Multi-Curve Term Structure Modeling, Closed Form Formulas

JEL Classification: E45, G13