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.
| Identifer | oai:union.ndltd.org:netd.ac.za/oai:union.ndltd.org:uct/oai:localhost:11427/27102 |
| Date | January 2017 |
| Creators | Dalton, Rowan |
| Contributors | Kienitz, Jörg, McWalter, Thomas |
| Publisher | University of Cape Town, Faculty of Commerce, Division of Actuarial Science |
| Source Sets | South African National ETD Portal |
| Language | English |
| Detected Language | English |
| Type | Master Thesis, Masters, MPhil |
| Format | application/pdf |
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