Modelling stochastic multi-curve basis

As a consequence of the 2007 financial crisis, the market has shifted towards a multi-curve approach in modelling the prevailing interest rate environment. Currently, there is a reliance on the assumption of deterministic- or constant-basis spreads. This assumption is too simplistic to describe the modern multi-curve environment and serves as the motivation for this work. A stochastic-basis framework, presented by Mercurio and Xie (2012), with one- and two-factor OIS short-rate models is reviewed and implemented in order to analyse the effect of the inclusion of stochastic-basis in the pricing of interest rate derivatives. In order to preclude the existence of negative spreads in the model, a constraint on the spread model parameters is necessary. The inclusion of stochastic-basis results in a clear shift in the terminal distributions of FRA and swap rates. In spite of this, stochastic-basis is found to have a negligible effect on cap/floor and swaption prices for the admissible spread model parameters. To overcome challenges surrounding parameter estimation under the framework, a rudimentary calibration procedure is developed, where the spread model parameters are estimated from historical data; and the OIS rate model parameters are calibrated to a market swaption volatility surface.

Grantor dc:publisher.institution

Division of Actuarial Science

Year dc:date.issued

2017

Author dc:creator

• Dalton, Rowan

Advisors dc:contributor.advisor

• Kienitz, Jörg
• McWalter, Thomas

Language dc:language.iso

eng

Handle dc:identifier.uri

http://hdl.handle.net/11427/27102

OAI identifier oai:identifier

oai:open.uct.ac.za:11427/27102