The Basis Goes Stochastic: A Jump-Diffusion Model for Financial Risk Applications

18 Pages Posted: 24 Aug 2016 Last revised: 26 Aug 2016

Date Written: August 25, 2016

Abstract

There are several pricing and risk model applications where the assumption of a deterministic LIBOR-OIS basis can lead to severe mispricing. By modeling such a basis using a jump-diffusion process, we show how stochastic basis can impact the valuation of specific deals such as zero-coupon swaps, as well as credit valuation adjustments and gap risk in particular. Explicit formulas are provided and numerical examples showcased.

Keywords: LIBOR-OIS basis, jump-diffusion dynamics, zero-coupon swap, swap gap risk

JEL Classification: G10; G12; G18; C60

Suggested Citation

Li, Minqiang and Mercurio, Fabio, The Basis Goes Stochastic: A Jump-Diffusion Model for Financial Risk Applications (August 25, 2016). Available at SSRN: https://ssrn.com/abstract=2827769 or http://dx.doi.org/10.2139/ssrn.2827769

Minqiang Li

Bloomberg LP ( email )

731 Lexington Avenue
New York, NY 10022
United States

Fabio Mercurio (Contact Author)

Bloomberg L.P. ( email )

731 Lexington Avenue
New York, NY 10022
United States

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