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

Masaaki Fujii, Yasufumi Shimada and Akihiko Takahashi
Additional contact information
Masaaki Fujii: Graduate School of Economics, University of Tokyo
Yasufumi Shimada: Capital Markets Division, Shinsei Bank, Limited
Akihiko Takahashi: Faculty of Economics, University of Tokyo

No CARF-F-196, CARF F-Series from Center for Advanced Research in Finance, Faculty of Economics, The University of Tokyo

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.

Pages: 26 pages
Date: 2009-12, Revised 2011-04
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Citations: View citations in EconPapers (30)

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