Impact of multiple curve dynamics in credit valuation adjustments under collateralization |
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Authors: | Giacomo Bormetti Damiano Brigo Marco Francischello Andrea Pallavicini |
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Institution: | 1. Scuola Normale Superiore, Piazza dei Cavalieri 7, 56126Pisa, Italy.;2. QUANTLab, via Pietrasantina 123, 56122Pisa, Italy.;3. Department of Mathematics, Imperial College, London, SW7 2AZUK.;4. Banca IMI, Largo Mattioli 3, 20121Milano, Italy. |
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Abstract: | We present a detailed analysis of interest rate derivatives valuation under credit risk and collateral modeling. We show how the credit and collateral extended valuation framework presented in Pallavicini et al. Funding valuation adjustment: FVA consistent with CVA, DVA, WWR, collateral, netting and re-hyphotecation, 2011], and the related collateralized valuation measure, can be helpful in defining the key market rates underlying the multiple interest rate curves that characterize current interest rate markets. A key point is that spot Libor rates are to be treated as market primitives rather than being defined by no-arbitrage relationships. We formulate a consistent realistic dynamics for the different rates emerging from our analysis and compare the resulting model performances to simpler models used in the industry. We include the often neglected margin period of risk, showing how this feature may increase the impact of different rates dynamics on valuation. We point out limitations of multiple curve models with deterministic basis considering valuation of particularly sensitive products such as basis swaps. We stress that a proper wrong way risk analysis for such products requires a model with a stochastic basis and we show numerical results confirming this fact. |
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Keywords: | Yield curve dynamics Multiple curve framework HJM framework Interest rate derivatives Basis swaps Counterparty credit risk Liquidity risk Funding costs Collateral modeling Overnight rates |
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