Download this Paper Open PDF in Browser

Non-Martingale Dynamics for Two Curve Derivatives Pricing

20 Pages Posted: 16 Apr 2012  

Mauricio Alvarez-Manilla

Mitsubishi UFJ Securities International plc

Date Written: April 16, 2012

Abstract

Given a forwarding LIBOR-style curve F corresponding to a fixed tenor (e.g. 6m) and an exogenous discounting curve D (e.g. an OIS curve or cross-currency basis swap curve) we build on Bianchetti's results to propose dynamics for the forward LIBOR-style rate collateralized by D.

In contrast with what other authors do (Bianchetti, Mercurio, Fujii, et al.) we do not assume that the collateralized forward rate is a martingale process under the corresponding forward risk neutral measure associated with the discount process. At time zero the collateralized forward rate is the forwarding curve rate multiplied by a quanto adjustment, but at reset time the expectation of the collateralized forward aligns with the forwarding curve rate.

In order to calculate the quanto adjustment we show how to construct a deterministic drift, which can be computed with the information available at time zero by bootstrapping (under certain assumptions on the spot swap rates). We extend the result to forward swap rates in the context of swap market models.

Keywords: non-martingale, two curve framework, multi-curve, collateralized forward rates, curve bootstrapping, multiple yield curves, forward curve, discount curve, basis adjustment, quanto adjustment, swap market models, LIBOR market models, interest rate derivatives, FRAs, swaps, swaptions, overnight index

JEL Classification: E43, G12, G13

Suggested Citation

Alvarez-Manilla, Mauricio, Non-Martingale Dynamics for Two Curve Derivatives Pricing (April 16, 2012). Available at SSRN: https://ssrn.com/abstract=2040581 or http://dx.doi.org/10.2139/ssrn.2040581

Mauricio Alvarez-Manilla (Contact Author)

Mitsubishi UFJ Securities International plc ( email )

Ropemaker Place
25 Ropemaker Street
London, EC2Y 9AJ
United Kingdom

Paper statistics

Downloads
216
Rank
119,636
Abstract Views
2,942