1
THE NEW SWAP MATH
FabioMercurio,OTCDerivativesandStructuredNotes
BloombergLP,NewYork
ABSTRACT
Inthisshortdocumentwedescribethevaluationformulaforswapsinamulticurvecontextandhintat
thedualcurvebootstrappingofLIBORprojectionsfrommarketinterestratedata.
ASSUMPTION ON THE DISCOUNT CURVE
Weintroducethefollowingassumptiononthe(assumedsingle)discountcurve,foragivencurrency:
ThediscountcurveistheOISzerocouponcurve,whichisstrippedfrommarketOISswapratesand
definedforeverypossiblematurity,T:
TPD(0,T)=POIS(0,T),
WherePD(t,T)denotesthediscountfactor(zerocouponbond)attimetformaturityT,whichis
assumedtocoincidewiththecorrespondingOISbasedzerocouponbondformaturityT.TheDstands
fordiscountcurve.
Therationalebehindthisassumptionisthatintheinterbankderivativesmarket,acollateralagreement
(CSA)isoftennegotiatedbetweentwocounterparties.TheCSAissettomitigatethecreditriskofboth
parties,allowingthemtoestablishbilateralmarktomarketcollateralarrangements.Weassumehere
thatthecollateral,typicallyabondorcash,isrevalueddailyatarateequal(orclose)totheovernight
rate,whichcanthusjustifytheuseofOISratesfordiscounting.
Inthefollowing,asinKijima,etal.(2009),thepricingmeasureswewillconsiderarethoseassociated
withthediscountcurve.ThisisalsoconsistentwiththeresultsofFujii,etal.(2009)andPiterbarg(2010),
sinceweassumeCSAagreementswherethecollateralratetobepaidequalsthe(assumedriskfree)
overnightrate.
DEFINITION OF FRA RATE AND ITS PROPERTIES
Definition 1
Classically,anFRAisdefinedaccordingtothefollowing1:
ThisdefinitionoftheFRArateslightlydiffersfromthatimpliedbytheactualmarketcontract.Thisabuseof
terminologyisjustifiedbecausethistheoreticalFRArateandthemarketcoincideinasinglecurvesetting.Inour
multicurvecasetheyaredifferent,buttheirdifferencecanbeshowntobenegligibleundertypicalmarket
conditions.
Considertimest,T1andT2,tT1T2.ThetimetFRArateFRA(t;T1,T2)isdefinedasthefixedratetobe
exchangedattimeT2fortheLiborrateL(T1,T2)sothattheswaphaszerovalueattimet.
DenotingbyQTDtheTforwardmeasurewhoseassociatednumeraireisthezerocouponbondPD(t,T),
by(riskadjusted)noarbitragepricing,weimmediatelyhave
(1)
WhereE DdenotesexpectationunderQ DandFtdenotestheinformationavailableinthemarketat
timet.
Intheclassicsinglecurvevaluation,i.e.,whentheLiborcurvecorrespondingtotenorT2T1coincides
withthediscountcurve,theFRArateFRA(t;T1,T2)coincideswiththeforwardrate:
(2)
Infact,theLiborrateL(T1,T2)canbedefinedbytheclassicrelation:
(3)
Sothatwecanwrite:
SinceFD(t;T1,T2)isamartingaleunderQ 2D,wecanthenconcludethat:
T
However,inourdualcurvesetting,(3)nolongerholds,sincethesimplycompoundedratesdefinedby
thediscountcurvearedierent, in general, from the corresponding Libor fixings.
OurFRArateisthenaturalgeneralizationofaforwardratetothedualcurvecase.Inparticular,we
noticethatatitsresettimeT1theFRArateFRA(T1;T1,T2)coincideswiththeLiborrateL(T1,T2).Moreover,
theFRArateisamartingaleunderthecorrespondingpricingmeasure.Thesepropertieswillprovetobe
veryconvenientwhenpricingswapsandoptionsonLiborrates.
PRICING OF INTEREST RATE SWAPS
LetusconsiderasetoftimesTa,...,Tbcompatiblewithagiventenor2andanIRSwherethefloatingleg
paysateachtimeTktheLIBORrateL(Tk1,Tk)setattheprevioustimeTk1,wherek=a+1,...,b,and
thefixedlegpaysthefixedrateKattimesTcS+1,...,TdS.
Underourassumptionsonthediscountcurve,swapvaluationisstraightforward.3ApplyingDefinition1
andsetting:
2
3
Forinstance,ifthetenoristhreemonthsthetimesTkmustbethreemonthspaced.
DetailsofthederivationcanbefoundinChibaneandSheldon(2009),Henrard(2009),Kijima,etal.(2009)and
Mercurio(2009).
TheIRStimetvalue,tothefixedratepayer,isgivenby:
WhereTkandT jdenote,respectively,thefloatinglegyearfractionfortheinterval(Tk1,Tk],andthe
fixedlegyearfractionfortheinterval(TSj1,TSj].
Thecorrespondingforwardswaprate,whichisthefixedrateKthatmakestheIRSvalueequaltozeroat
timet,isthendefinedby:
(4)
Intheparticularcaseofaspotstartingswap,withpaymenttimesforthefloatingandfixedlegsgivenby
T1,...,TbandT1S,...,TdS,respectively,withTb=TdS,theswapratebecomes:
(5)
WhereL1(0)istheconstantfirstfloatingpayment(knownattime0).
AsalreadynoticedbyKijima,etal.(2009),neitherlegofaspotstartingswapneedstobeworthpar
(whenafictitiousexchangeofnotionalsisintroducedatmaturity).However,thisisnotaproblem,since
theonlyrequirementforquotedspotstartingswapsisthattheirinitialNPVmustbeequaltozero.
Acomparisonbetweenthetwoswaprateformulasinthesingleanddualcurvesetupsisprovidedin
Table1.Inthesinglecurvecase,theuniquelydefinedzerocouponcurvecoincideswiththediscount
curve.
Table 1: Comparison between old and new formulas for forward swap rates.
STRIPPING THE LIBOR PROJECTIONS
Astraditionallydoneinanybootstrappingalgorithm,equation(5)canbeusedtoinfertheexpected
(riskfree)ratesLkimpliedbythemarketquotesofspotstartingswaps,whichbydefinitionhavezero
value.Giventhat,bytheaboveassumption,thediscountcurvehasalreadybeenbootstrappedfrom
marketOISrates,thediscountfactorsPD(0,T),T {T1,...,Tb,T1S,...,TdS}enteringformula(5)areallknown.
TheFRAratesLk(0)canthusbeiterativelyderivedbymatchingthemarketquotesofratesbasedonthe
sameLibortenorastheoneunderconsideration.4
ThebootstrappedLkcanthenbeused,inconjunctionwithanyinterpolationtool,topriceothe
marketswapsbasedonthesameunderlyingtenor.AsalreadynoticedbyBoenkostandSchmidt(2005)
andbyKijima,etal.(2009),theseotherswapswillhavedierentvalues,ingeneral,thanthoseobtained
bystrippingdiscountfactorsthroughaclassic(singlecurve)bootstrappingmethodappliedtoswap
rates:
SothatthechoiceofdiscountfactorsPD(0,TjS)heavilyaectstheIRSvalueofothemarketfixedrates
K.
DetailsonasimilarcurveconstructionmethodologycanbefoundinChibaneandSheldon(2009),Henrard(2009)
andFujii,etal.(2009).TheanalysisinFujii,etal.(2009)ismorethorough,sincetheyconsiderageneralcollateral
rateinamulticurrencyenvironment.
REFERENCES
Boenkost,W.andW.Schmidt(2005).CrossCurrencySwapValuation.WorkingPaper,HfBBusiness
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Chibane,M.andG.Sheldon(2009).BuildingCurvesonaGoodBasis.WorkingPaper,ShinseiBank.
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http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1332205
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