Sunteți pe pagina 1din 32

Closed Form Approximation of Swap Exposures

Heikki Seppala, Ser-Huang Poon and Thomas Schroder


March 21, 2013

Heikki Sepp
al
a (heikki.seppala@manchester.ac.uk) and Ser-Huang Poon (ser-huang.poon@mbs.ac.uk) are
both at the Manchester Business School, Thomas Schroder (t.schroeder@eib.org) is at the European Investment
Bank. Heikki Sepp
al
a is a Marie Curie fellow funded by the European Communitys Seventh Framework Programme FP7-PEOPLE-ITN-2008 under grant agreement number PITN-GA-2009-237984 (project name: RISK).
The funding is gratefully acknowledged. The opinions expressed in this article are the sole responsibility of the
authors and do not necessarily reflect the views of the European Investment Bank.

Closed Form Approximation of Swap Exposures


Abstract

The collapse of the Lehman Brothers and the 2008 financial crisis have made
Libor risky and increased liquidity cost of some currencies. The basis spreads in
tenor basis swap and cross currency basis swap are substantial post 2008 crisis. No
model exists to date that tackles these new phenomenon. We propose a two-factor
mean reverting Gaussian model for the basis spread, and use it to derive a closed
form expression for the expected exposure of tenor basis swap. An approximation
for the expected exposure of the cross currency basis swaps is derived based on its
upper and lower bounds. We also describe how our model can be calibrated and
show that the calibration of the two-factor Gaussian model to the time series of
term structure of basis spread is quite good. Our analytical solutions can be used to
value swaptions, and as sanity checks for CVA, CVA VaR and Basel risk capital for
counterparty credit risk exposure of OTC derivatives.

JEL Classification: G13, G32, G21


Keywords: Tenor basis swap, cross currency swap, swaption, credit valuation adjustment, expected exposure, Basel

Closed Form Approximation of Swap Exposures


1

Introduction

After the banking crisis of 2007-2008 and the collapse of the Lehman Brothers, companies and
financial institutions have greatly become more risk aware and the new regulations in Basel
III (2011) drastically tightened up the reporting of over-the-counter (OTC) derivatives. Counterparties to the derivative trade made adjustments for the credit worthiness of each other, a
practice now known as credit valuation adjustment (CVA). CVA is waived if the counterparty
chooses to post collateral to reduce the cost of default. The posting of collateral is normally
bilateral unless one of the counterparties is a sovereign or a government agency. Unilateral CVA
is also used in Basel III for determining capital charge against counterparty exposure and the
estimation of CVA VaR (Value at Risk). All such capital risk charge calculations begin with the
expected positive marked to market value of OTC derivatives. In this paper we derive closed
form approximations for expected exposures of tenor basis swaps and cross currency basis swaps.
The presence of basis spread and its volatility have been very prominent during the financial
crisis 2008 (see Figure 1). To date, very little attempt has been made in modeling and estimating
the effect of basis spread on swap risk exposure. We model the tenor basis spread and the cross
currency basis spread using a mean reverting Gaussian two-factor model with deterministic shift,
which allows closed-form solutions and is relatively easy to calibrate. Our model is simpler than
that used in Kenyon and Stamm (2012, 7.2) for pricing fixed-for-floating interest rate swaption,
and our formulation leads to closed form approximations. Our approximations can be used as a
sanity check in trading environment, in cross checking CVA implementation and validation, for
approximating CVA VaR and expected shortfall. Our approximations can also be used to crosscheck the price of stand-alone options on tenor basis swap and cross-currency swap omitting
3

50
100

CC basis spread (bp)

the portfolio effect of counterparty default risks.

2006

2008

2010

2012

Date

Figure 1: Time series of cross currency basis swap spreads for EURUSD with maturities 1 year
(black solid), 10 yrs (red dashed), 30 yrs (blue dotted) for the period from 1 February 2006 to
30 October 2012.
The paper is organized as follows. Section 2 introduces tenor basis swap and a model for the
swap spread. A closed-form formula was derived for the expected exposure of tenor basis swap.
Section 3 deals with cross currency basis swap. Section 4 gives approximation formulas for the
expected exposure of cross currency basis swap. Section 5 describes the calibration procedures
of our basis spread model and presents some results. Proofs are given in the appendix.

Tenor basis swap

In a tenor basis swap (TBS), interest rates of different tenors are exchanged. We consider here
3M vs. 6M Libor tenor basis swap with quarterly payment dates T1 , ..., T2n and fixing dates Tk1 ,
for k = 1, ...2n, on the 3M side, and semi-annual payment dates T2i and fixing dates T2(i1) , for

i = 1, ..., n, on the 6M side. We denote the notional by N , the x month Libor rates for time
period [t, t + xM ) by LxM
t , and the 3M vs. 6M basis spread for period [t, T ] by t,T . The spread
t,T can be derived from the difference between two fixed-for-floating swaps with identical fixed
legs; 6M vs fixed and 3M vs fixed (see Kenyon, Stamm, 2012, 5.1.1). The spread is by convention
included in the leg with the shorter tenor as the longer (riskier) rate is higher because of credit
and liquidity issues. That is why the tenor basis spread is basically always positive (see figure
2) in contrast to cross currency basis swap (Figure 1). These spreads have existed for a long

30
20
0

10

Tenor basis spread (bp)

40

time but were negligibly small before the 2008 crisis (see figures 2 and 3).

2007

2008

2009

2010

2011

2012

2013

Date

Figure 2: Time series of tenor basis swap spreads with maturities 1 year (black solid), 10 years
(red dashed), 30 years (blue dotted) for period 1 January 2007 23 October 2012.
Figure 3 shows that the spread decreases when the maturity increases. This is because the
spread can be considered as risk and liquidity premium, which is more prominent over the short
maturity. As the number of payments increases for the longer contract, the premium included
in each payment is lower.
At contract initialization, the value of the T BS, from the 6M payers perspective, can be
5

40
30
20
10
0

Tenor basis spread (bp)

10

15

20

25

30

Maturity of swap

Figure 3: The spread term structures on 1 January 2007 (black solid), 13 October 2008 (red
dashed) and 23 October 2012 (blue dotted).

written as

T BS0 (0) = N

" 2n
X

k3M

3M
F0,T
k1

+ 0,T D(0, Tk )

n
X

#
6M
i6M F0,T
D(0, T2i )
2(i1)

i=1

k=1

where N is the notional, D is the discount factor, k3M and i6M are year count fractions between
3M
6M
fixing and payment dates, and Ft,T
and Ft,T
are the forward Libor rates. The basis spread is
i
k

set such that the contract has a zero value at inception, i.e. T BS0 (0) = 0.1
At time t, the value of this contract is given by

T BS0 (t) = N

2n
X

3M
k3M Ft,T
+ 0,T D(t, Tk )
k1

k=j

where
j =

n
X

6M
i6M Ft,T
D(t, T2i ) ,
2(i1)

(1)

i=j

2j 1

if t [T2(j1) , T2j1 )

2j

if t [T2j1 , T2j )

At time t, the market value of a new contract can be written as


"
T BSt (t) = N t,Tj 1 L3M
+ t,T D(t, Tj 1 ) +
t


2n
X

3M
k3M Ft,T
+ t,T D(t, Tk )
k1

k=1

"
N t,T2(j1) L6M
t D(t, T2(j1) ) +

n
X

#
6M
i6M Ft,T
D(t, T2i )
2(i1)

(2)

i=1

= 0

This means that T BS0 (t) can be valued with a reversal contract by subtracting (2) from (1) as
follows:
T BS0 (t) = (0,T t,T ) N

2n
X

k3M D(t, Tk ).

(3)

k=j

Equation (3) shows that the value of a tenor basis swap depends entirely on the changes in the
basis spread t,T and the discount factor D(t, Tk ). Note that this formula holds for t [Tj 1 , Tj )
and we do not have to treat separately the cases where Tj1 is odd or even.
1

In practice the spread and one of the forward curves (depending on the currency) are given by the market
and the other forward curve is built such that T BS 0 (0) = 0 (see Kenyon and Stamm, 2012, 5.2).

Given the 6-month Libor forward curve, we can solve the forward spread at time t from (2)
as follows:
6M
3M
t,T = (St,T
St,T
)

A6M
t,T
,
A3M
t,T

(4)

3M
6M
where A is the annuity factor and St,T
and St,T
are swap rates of fixed-for-floating swap with

frequency 6M on the fixed side, i.e.

A6M
t,T

= t,T2(j1) D(t, T2(j1) ) +

n
X

i6M D(t, T2i ),

i=j

A3M
t,T = t,Tj 1 D(t, Tj 1 ) +

2n
X

k3M D(t, Tk ),

k=j
3M
St,T

6M
St,T

2.1

=
=

t,Tj 1 L3M
t D(t, Tj 1 ) +

P2n

k=j

3M
k3M Ft,T
D(t, Tk )
k1

A6M
t,T
t,T2(j1) L6M
t D(t, T2(j1) ) +

Pn

i=j

6M
i6M Ft,T
D(t, T2i )
2(i1)

A6M
t,T

Expected exposure of tenor basis swap

Credit exposure becomes a risk only when the value of the OTC derivative is positive. A formal
definition of expected exposure is provided below.
Definition 1 Let V (t) be the value of a contract at time t. Then the exposure at time t is
E[V (t)] = max{V (t), 0} and the expected exposure at time t seen from time s is

EEs [V (t)] = Es [max{V (t), 0}] := E[max{V (t), 0}|Fs ],

where Fs is the sigma algebra containing all the information up to time s.

We assume the basis spread dynamics is described by

t,T

1
Et
=
T t

s ds

(5)

t = xt + yt + (t)
dxt = axt dt + x dWtx
dyt = byt dt + y dWty

where : [0, T ] R is a deterministic function of time, and both xt and yt mean revert to zero
at the speed a and b, respectively.
Proposition 2 From the basis spread dynamic defined in (5), we have

a(tu)

x0 + x
e
+ e y0 + y
eb(tu) dWuy + (t)
0
0


T
1
at
bt
=
(t, T, a)e x0 + (t, T, b)e y0 +
(s)ds
T t
t


t
t
1
a(tu)
x
b(tu)
y
(t, T, a)x
e
dWu + (t, T, b)y
e
dWu .
+
T t
0
0

t = e
t,T

at

bt

dWux

In particular, xt , yt , t and t,T are Gaussian with means


x (t) := E[xt ] = eat x0
y (t) := E[yt ] = ebt y0
(6)
at

(t) := E[t ] = e

bt

x0 + e y0 + (t)


T
1
at
bt
(t) := E[t,T ] =
(t, T, a)e x0 + (t, T, b)e y0 +
(u)du ,
T t
t

and variances
x (t) := var[xt ] = x2 (0, t, 2a)
y (t) := var[yt ] = y2 (0, t, 2b)
(7)
(t) := var[t ] =

x2 (0, t, 2a)

(t) := var[t,T ] =

where (t, T, a) =

y2 (0, t, 2b)

1
1
2
(t,
T,
a)
var[x
]
+
(t, T, b)2 var[yt ],
t
(T t)2
(T t)2

1eat
.
a

The proof of this proposition follows from the results in Brigo and Mercurio (2006, 4.2). Note
that this model allows the basis spread to be negative.2
Theorem 3 Under the Gaussian 2-factor model and assuming independence between the discount rate and the basis spread for t [Tj1 , Tj ),
2n

EE[T BS0 (t)] = [ N 0 (d) + ( 0,T )(1 (d))]


k3M E[D(t, Ti )],
k=j

where and are given in equations (6) and (7), is cumulative distribution function of
standard normal distribution and
d=

0,T
.

As an example, suppose we have a 5-year Euribor 3M for 6M tenor basis swap initiated on 2
July 2012. The expected exposure profile at initialization is shown in figure 4. Our basis spread
model was calibrated to the basis spread term structure on 2 July 2012. As shown in figure 4,
the expected exposure drops on each 3M leg payment date.
The assumption that the discount rate and the tenor basis spread are independent could be
unrealistic, because higher Libor rate could be due to increased riskiness or liquidity shortage
of the Libor rate, and the basis spread should widen. The higher Libor rate would have an
2

According to Brigo and Mercurio (2006, 4.2.1) the two-factor model in (5) is equivalent to the Hull-White
two-factor model, with t following a mean reverting Gaussian process with a stochastic long-run mean that is
itself mean reverting. The second specification is more intuitive but harder to calibrate.

10

0.10
0.08
0.06
0.04
0.00

0.02

Expected exposure (%)

Time (yrs)

Figure 4: Expected exposure profile of a 5-year tenor basis swap starting on 28 September 2012.
immediate negative impact on the discount factor. So the assumption of independence between
basis spread and discount factor could lead to an over-estimation of the changes in the value of
tenor basis swap, and an overestimation of the expected exposure.

Cross Currency Basis Swap

The valuation of cross currency basis swap (CCBS) is more complicated than tenor basis swap
since, apart from interest rate and tenor basis, the value of CCBS also depends on exchange
rate and cross currency basis. For ease of exposition, we consider below a cross currency swap
with the same tenor on both legs thereby allowing us to omit the confounding effects of tenor
basis spread. Before the financial crisis, such a CCBS predominantly contained exchange rate
risk. Sometimes, the swap quotes included a small basis spread to reflect the currency relative
shortage. However, due to the severe dollar shortage during and since the 2008 crisis, there is

11

now a significant and fluctuating spread involved in such a basis swap quoted as 3M USD Libor
flat vs 3M Euribor + spread. In the case of EURUSD CCBS, the spread is negative since 2008,
with the 5Y spread reaching the peaks of over -60bp in 2009 and in 2011 (see figure 1).
Suppose we have a EURUSD T -period CCBS initiated at time 0 with notional N0e and N0$ ,
exchange rate S0 =

N0$
,
N0e

and a basis spread 0,T . At maturity T , the notional are to be returned

in the exact amount thereby preserving the exchange rate at inception. The FX spot rate St ,
expressed as USD per EUR, is time varying. The contract has payments at dates (Ti )ni=0 , with
T0 = 0, Tn = T . At time 0, the value of the contract in euros (from the epayers perspective)
can be written as
CCBS0e (S0 )

= D

(0, T )N0e

n
X

Ti1 ,Ti De (0, Ti )(rTei1 ,Ti + 0,T )N0e

i=1
n

N$ X
N$
+ D (0, T ) 0 +
Ti1 ,Ti D$ (0, Ti )rT$ i1 ,Ti 0
S0
S0
i=1
$

(8)

=0
where rTei1 ,Ti (rT$ i1 ,Ti ) is the Euribor ($Libor ) at time Ti1 for the period [Ti1 , Ti ), and Ti1 ,Ti
is the year fraction between Ti1 and Ti , D$ (0, T ) is from the 3M $-Libor curve (typically the
US OIS, Overnight Index Swap rates) and De (0, Ti ) is the basis adjusted discount factor such
that the value of the swap is 0 at inception (see Kenyon and Stamm, 2012, 6.1).
At time t [Tj1 , Tj ) the value of this CCBS for the epayer is
CCBSte (S0 )

= D

(t, T )N0e

n
X

Ti1 ,Ti De (t, Ti )(rTei1 ,Ti + 0,T )N0e

i=j
n

S0 N0e X
S0 N0e
$
$
+ D (t, T )
+
Ti1 ,Ti D (t, Ti )rTi1 ,Ti
.
St
St
i=j

(9)

The basis spread, FX rate and OIS rates are likely to have changed since inception, thus the
contract value is not zero at time t. We can value the CCBS in (9) by a reversal contract with
a notional value Nte = N0e , and Nt$ = St N0e =
Nt$
St

N0$
S0

St
N $.
S0 0

Then by making use of the fact that

, the cash flows and the value of the new contract can be written as
12

CCBSte (St )

= D

(t, T )N0e

n
X

Ti1 ,Ti De (t, Ti )(rTei1 ,Ti + t,T )N0e

i=j
n

N$
N$ X
Ti1 ,Ti D$ (t, Ti )rT$ i1 ,Ti 0
+ D (t, T ) 0 +
S0
S0
i=j
$

(10)

= 0.
Subtracting (10) from (9), we get, by setting N0e = $1,

CCBSte (S0 )

= (t,T
|

n
X


S0
1
0,T )
Ti1 ,Ti D (t, Ti ) + D (t, T )
St
i=j
{z
}
{z
} |
e

(11)

C(t)

A(t)

A(t)
(t,T 0,T )(Tn t)



.
S0
C(t)
1
St

where A(t) and C(t) denote the spread and the FX components of the CCBS respectively.
As an illustration, we consider a 4-year CCBS with quarterly payments starting on 1 April
2008 with notional 10Me. The unreported spreads are approximated by appropriate weighted
averages of the reported market spreads, e.g., a 3 year 9 month spread would be approximated
by t,3 9 = 0.75t,4 + 0.25t,3 . figure (5) plots the CCBS value and its two subcomponents as
12

they evolve through time up to maturity. As we see in Figure 5 the FX-part, which was the value
of the CCBS before crisis, still approximates the CCBS fairly well, but there is a slight deviation
especially in when the time to maturity is 2 3.5 years. For a longer contract the deviation
would potentially be larger. In this example, the FX component approximation is higher than
the CCBS value at every time point, but this needs not always be the case. It is obvious that
the CCBS could contain very large exposure at maturity due to the FX component, which is not
the case in tenor basis swap, whose exposure converges to at contract maturity. Comparison of
the evolution of the value of CCBS in Figure (5) to the expected exposure profile of the tenor
basis swap shown in Figure 4 illustrates this fact.
Figure 6 plots the cross currency basis swap spread term structures on three different dates
13

0.25
0.20
0.15
0.10
0.00

0.05

Value

2009

2010

2011

2012

Date

Figure 5: Value of a 4-year CCBS initiated on 1 April 2008 (black solid), the approximation of
FX component,C, (red dashed) and the approximation of spread component, A, (blue dotted)
during the life of the contract.
and the average over our sample period. The steepness of the term structure is very different on
the three dates with the short term spread being a lot more volatile than the long term spread.
As such, the term (t,T 0,T ) needs not always be negative. Nevertheless, in our data period,
the spread component tends to decrease instead of increase the value of the CCBS. However,
since the EURUSD basis spread was almost non-existent before 2008, we do not have sufficient
data to examine closely on how the spread component affects the value of CCBS over the long
term.
The value CCBSte (S0 ) is dominated by the FX component, C(t), especially at short maturity.
Figure 5 shows a clear dominance of the FX component on the CCBS valuation. The spread
component reached its peak at 300bp just after 2009, but in general has a value of much less than


S0
100bp in absolute term. In contrast, the changes in the FX component St 1 can exceed
25%. When the time to maturity is long, the spread component, A, has many terms in the
summation. But, as shown in figure 6, the changes in the long term spreads are very small.
This, combined with the discounting effect, means that the spread component, A, is always
14

0
50
150

100

Spread (bp)

10

15

20

25

30

Time (yrs)

Figure 6: Spread term structures on dates 1 April 2008 (blue dotted), 25 November 2008 (red
dashed), 2 May 2012 (green dashdotted) and average over the period 1 April 2008 to 2 May
2012 (black solid).
relatively small. The FX component, C, gets smaller on average as time to maturity increases
because of the discounting effect, but the FX rate changes can be very volatile. As such, the FX
component dominates completely when the CCBS is closed to maturity.

Expected exposure of CCBS

From the analysis in the previous section, it is clear that a closed form formula for the expected
exposure for the CCBS is difficult to obtain. Our objective here is to find a simple closed form
approximation for the expected exposure of CCBS. By Definition 1, the exposure and expected
exposure of CCBS, at time t, are

E[CCBSte (S0 )] = max{A(t) + C(t), 0}


EE0 [CCBSte (S0 )] = E0 [max{A(t) + C(t), 0}].

15

According to (11) the value of the CCBS depends on the evolution of the 3M Libor rates on
both currencies, the instantaneous cross currency basis swap spread t and the FX rate St . From
exchange rate parity, the FX rate also depends on the risk-free (OIS) rates of both currencies
and the OIS spread. An examination of the data post 2008 crisis suggests that all the interest
rates are correlated but the spreads and interest rates do not appear to be strongly correlated.
Hence, we assume in the following section that the cross currency basis spread and the interest
rates are not correlated. This assumption is essential in order to achieve our simple closed form
approximation.

4.1

Bounds for expected exposure

The following proposition gives approximations for the lower and the upper bounds of the expected exposure.
Proposition 4 We have that

1
[EC(t) + EA(t) + |E|C(t)| E|A(t)||] EE0 [A(t) + C(t)] EE0 [C(t)] + EE0 [A(t)]
2

(12)

The lower bound of CCBS (t) is closed to the FX part, C(t), of the expected exposure, which
is convenient since most of the time A(t) and C(t) are of different sign and negatively correlated.
This suggests that EE0 [CCBSte (S0 )] EE0 [C(t)]. However, we should be very careful with this
inference since we do not want to under estimate the exposure. On the other hand, the upper
bound in (12) is likely to be over pessimistic as it assumes that A(t) and C(t) always have the
same signs.

16

4.2

Spread component of CCBS

To apply Proposition 4, we need to calculate E[A(t)], E[|A(t)|] and EE0 [A(t)] for the spread
component, A. From (11), we rewrite the spread component, A(t), as

A(t) = (t,T 0,T )

n
X

Ti1 ,Ti D (t, Ti ) =

i=j

n
X

Ai (t)

i=j

Ai (t) := (t,T 0,T )Ti1 ,Ti De (t, Ti )


De (t, T ) = e

T
t

(rse +t,T )ds

where rse is the 3M Euribor spot rate.


Using this discount factor, we have the following theorem.
Theorem 5 Under the Gaussian 2-factor model and assuming independence between the spot
interest rate r and the spot spread we have, for t [Tj1 , Tj ),

E[A(t)] =

n
X

E[Ai (t)]

i=j

E[A(t)+ ] =
E[|A(t)|] =

n
X
i=j
n
X

E[Ai (t)+ ]
E[|Ai (t)|]

i=j

where

E[Ai (t)] = Bt,Ti C,i [ (Ti t) 0,T ]

(13)

E[Ai (t)+ ] = Bt,Ti C,i [ N 0 (d) + ( (Ti t) 0,T )(1 N (d))]

(14)

E[|Ai (t)|] = Bt,Ti C,i [2 N 0 (d) + ( (Ti t) 0,T )(1 2N (d))]

(15)

17

with and given in equations (6) and (7),


h T e i
Bt,Ti = Ti1 ,Ti E e t rs ds ,
C,i = e(Ti t) +
d=

4.3

(Ti t)2
2

and

0,T ( (Ti t) )
.

FX component of CCBS

In order to use Proposition 4, we also need to find E[C(t)], E[|C(t)|] and EE0 [C(t)]. Each of
these components can be separated into E[C(t)+ ] and E[C(t) ] as follows:
E[C(t)] = E[C(t)+ ] E[C(t) ],
E[|C(t)|] = E[C(t)+ ] + E[C(t) ] and
EE0 [C(t)] = E[C(t)+ ].
Notice that C(t)+ = max{C(t), 0} resemblance to the payoff of a call option to buy

1
S0

euros for

one dollar at time t;

n

 o
n
max{C(t), 0} = max D$ (t, T ) SS0t 1 , 0 = S0 D$ (t, T ) max S1t
whereas C(t) resemblance to the payoff of a put option to sell

1
S0

1
,0
S0

euros for one dollar at time t.

If we assume independence between the FX rate and the 3M $-Libor rate (which is not entirely
true), these call and put option values can be obtained directly from market data on valuation
date.
In fact, according to the example in the previous section, the simplest approximation for the
expected exposure of CCBS at time t is the expected exposure of the FX component, C(t), i.e.,

EE0 [CCBSte (S0 )]




 $

S0
E D (t, T ) E max
1, 0 .
St

18

(16)

The data post 2008 suggests that the spread component, A, and the FX component, C, have
different signs in most cases. So it would be tempting to use equation (16) as an upper bound for
the expected exposure of CCBS. However, one should be careful with this since the data period
is relatively short and we do not have any economic theory to justify this negative relationship.

Calibration

The closed form approximation we derived for the exposure of tenor basis swap and cross currency
basis swap in the previous sections depends on how well the two-factor Gaussian model we
proposed for the basis spread fit the market observed spread. In this section, we will show that
this empirical fit is quite good. Our calibration approach follows the calibration of credit spreads
in Brigo and Alfonsi (2005). We consider the integrated process and define

1 T
s ds,
0,T =
T 0

1 T
Z0,T =
xs + ys ds,
T 0

1 T
(s)ds.
(0, T ) =
T 0

(17)

The procedures involve first fitting Z0,Ti to the market observed basis spread term structure
0,T1 , ...,
0,Tn } as closely as possible. After this, is chosen such that
{

0,T =E0,T = EZ0,T + (0, Ti )

i
i
i

for all Ti .
Since (17) does not contain any volatility information, we adopt the bond price calculation
in Brigo and Mercurio (2005, Theorem 4.2.1) and reproduced below:
Theorem 6 (Brigo and Mercurio, 2005, Theorem 4.2.1, Zero Coupon Bond Price) Supposed

19

the dynamic of the instantaneous short rate is given by a two-factor Gaussian model

r (t) = x (t) + y (t) + (t) ,

then the price at time t of a zero coupon bond maturing at time T is3

Ee(0,T )Z0,T = e(0,T ) T (a,T )x0 T (b,T )y0 + 2T 2 V (T ) ,

where
(1 eaT )
a

2
2eaT
e2aT
3
x

V (T ) = 2 T +
a
a
2a
2a

2 
2bT
bT
y
e
3
2e
+ 2 T+

b
b
2b
2b
x y
+ 2xy
(T (a, T ) (b, T ) + (a + b, T )) .
ab

(a, T ) =

From Theorem 6, we can write

(0,T )f (x0 ,y0 ,a,b,x ,y ,;T )

e0,T = Ee(0,T )Z0,T = e(0,T )EZ0,T + 2 var(Z0,T )=e

1
0,T
f (x0 , y0 , a, b, x , y , ; T ) = EZ0,T var (Z0,T )
2

(18)

where c is a constant representing the error of the fit. From Theorem 6,

f (x0 , y0 , a, b, x , y , ; T ) =

1
1
1
(a, T )x0 + (b, T )y0
V (T )
T
T
2T 2

(19)

Equation (18) will be calibrated to the market observed term structure of the basis spread for
all relevant T .
We can impose some restrictions for the minimisation. In our case the parameters a, b, x
3

1,

Function is positive and decreasing, and V is positive. In the limit, we have limT 0
limT T1 (a, T ) = 0 and limT 0 VT(T2 ) = 0, limT VT(T2 ) = 0.

20

1
T

(a, T ) =

and y must be positive so that we calibrate the model by minimizing the quadratic difference
and f , i.e., solve arguments from
between

min

x0 ,y0 ,a,b,x ,y ,

n 
X


2

0,Ti f (x0 , y0 , a, b, x , y , ; T ) + 1A ,

(20)

i=1

where
A = {(x0 , y0 , a, b, x , y , ) R7 : a, b, x , y > 0}.
The last term on the right-hand side of (20) imposes a penalty determined by parameter if
the positivity conditions on parameters a, b, x and y are not satisfied. If we want to have more
restrictions or fix some parameters, we can add these restrictions to A. Our calibration results
suggest that for cross currency basis spread, x0 and y0 should be of different sign, whereas for
tenor basis spread, x0 and y0 are both positive.
When all the parameters are fitted, we solve the values of the mean integral of the deterministic drift from

0,T f (x0 , y0 , a, b, x , y , ; Ti )]
Ti ) =
0,T EZ0,T = 1 2 V (Ti ) + [
(0,
i
i
i
2T

(21)

The values of depend


for all i. We then fit a function to these points to get fitted values of .
on the choice of the functional form of . Here, we do not extract the values of because we are
not modelling the spot spreads. Nevertheless, to recover , must be differentiable4 . Then
from (17)
0,T f () in equation (21).
One could try to find a smooth approximation for the error function (Ti ) :=
i
For example Nelson-Siegel-Svensson method (Svensson, 1994) could be used to recover . The derivative of V
can be obtained using Mathematica. For the calibration of Nelson-Siegel-Svensson method, see Gilli, Groe, and
Schumann (2010).
4

21

(t)dt = T (0, T )
0

(t) =

5.1

d
d
[t(0, t)] = (0, t) + t (0, t).
dt
dt

Calibration results

The term structure of basis spread does not contain information about volatility, which is the
first major problem. We use the bond equivalent to get the volatility term artificially appear
and set

e0,T = Ee(0,T )Z0,T = e(0,T )EZ0,T + 2 var[Z0,T ]

The volatility term should really be treated as input parameter here.


In the calibration, we first fit the dynamical part as well as possible to the term structure.
That is we obtain x0 , y0 , a, b, x , y and xy by minimising
M 
X
i=1

0,T EZ0,T + 1 var[Z0,T ]

i
i
i
2

2

Ti1.5 ,

where M is the number of observations in the term structure, and Ti1.5 is our choice of a weighting
scheme to give a greater emphasis on calibrating the long maturity swap spread well .
The deterministic part, (0, t), is a function such that for each i = 1, ..., M

0,T EZ0,T ,
(0, Ti ) =
i
i

where Z holds the calibrated parameters.


Figures 7, 8 and 9 present our calibration results. Figure 7 shows the fit to 1 year, 5 year,
10 years and 30 years basis spread for EURUSD cross currency basis swap. Figure 8 shows

22

10
5

Basis points

15

20

40
30
20
10
10

Basis points

2007

2009

2011

2013

2007

2009

2013

2011

2013

Date

6
0

Basis points

10
5

Basis points

15

Date

2011

2007

2009

2011

2013

2007

Date

2009
Date

Figure 7: Calibration performance of dynamic part for 1Y (top left), 5Y (top right), 10Y (bottom
left) and 30Y spreads (bottom right). The parameters a = 0.05, x = 0 are fixed and the rest
of the parameters are calibrated. Black solid line is the actual term structure, red dashed line
is the dynamic part of daily calibrated model and blue dotted line is the deterministic part.

23

0.004
y0

0.000

0.002

0.0010
0.0000

x0

2007

2008

2009

2010

2011

2012

2013

2007

2008

2009

2011

2012

2013

2011

2012

2013

Date

0.00018

sigmay

0.00016

1.1000
1.0997

1.1003

Date

2010

2007

2008

2009

2010

2011

2012

2013

2007

2008

2009

Date

2010
Date

20

Figure 8: Calibrated parameters x0 , y0 , b and y .

15

0.0

10

Spread (bp)

0.4

0.2

Spread (bp)

0.6

10

15

20

25

30

10

25

30

time(yrs)

20

10

Spread (bp)

30

20
15

10

10

Spread (bp)

20

40

time(yrs)

15

10

15

20

25

30

time(yrs)

10

15

20

25

30

time(yrs)

Figure 9: Basis term structure (black), calibrated dynamical part of the model (red dashed) and
deterministic part of the model (blue dotted) on dates 1 January 2007, 29 September 2008, 29
October 2010 and 20 July 2012.
24

the calibrated values for x0 , y0 , b and y ; note that x0 and y0 vary a lot through time, but b
and y are practically constant. Figure 9 shows the fit of the model to the basis spread for
different dates. Apart from the very short maturity spread, our two factor Gaussian model fit
the basis spread term structure reasonably well. Finally, one should note that the two mean
reversion rates, a and b, and the two volatilities, x and y , should be considered as inputs in
the calibration as they are basically unaffected by calibration. However, the optimal choice of
their (initial) values is not clear. A more flexible parameter setting could fit the dynamical part
capture the the term structure better, but the stability of the calibrated parameters values could
suffer.
We are interested in the evolution of t,T with respect to t. We try to model this evolution
making t,T time homogeneous,

t,T

1
=
Et
T t


s ds ,

which is quite intuitive, but it does not seem to be good as the is zero mean reverting and hence
t,T is decreasing on expectation. This is not realistic according to the market observed data;
the shorter maturity spreads are generally a lot higher higher than the long maturity spreads.
Another choice is to model the evolution of t,T by setting

t,T

1
=
T t

T t

s ds,
0

which may be less intuitive, but should give more realistic values for shorter spreads.

25

References
Basel Committee on Banking Supervision, Basel III: A global regulatory framework
for more resilient banks and banking systems,

December 2010 (rev June 2011),

www.bis.org/publ/bcbs189.pdf.
Brigo, D., Alfonsi, A. (2005): Credit Default Swaps and Option Pricing with SSRD Stochastic
Intensity and Interest-Rate Model, Finance & Stochastics, Vol. IX(1), 2005.
Brigo, D., Mercurio, F. (2006): Interest Rate Models - Theory and Practice, Second edition,
Springer.
Gilli, M., Groe, S., Schumann, E., (2010), Calibrating the Nelson-Siegel-Svensson model,
COMISEF working paper series, WPS-031.
Kenyon, C., Stamm, E., (2012), Discounting, Libor, CVA and Funding, Interest Rate and Credit
Pricing, (Applied Quantitive Finance) Palgrave Macmillan.
Siegel, J., (1972), Risk, Interest Rates and the Forward Exchange, The Quarterly Journal of
Economics, Vol. 86, No. 2 (May, 1972), pp. 303-309. 5.1
Svensson, L., (1994), Estimating and Interpreting Forward Interest Rates: Sweden 19921994.
IMF Working Paper 94/114, 1994.

26

Appendix
Proof of Theorem 3
We have that
"
(t,T 0,T )

EE0 [T BS0 (t)] = E



= E (t,T 0,T )+

n
X
i=2j
n
X

!+ #
i3M D(t, Ti )
i3M E[D(t, Ti )]

i=2j

and

E (t,T 0,T )

(x 0,T )e

(x )2
2

0,T

where d =

0,T

dx

z 2 dz
( z + 0,T ) e 2
2

N 0 (d) + ( 0,T ) (1 N (d)),

Here we made the change of variable z =

Proof of Theorem 4
The fact that X + = 21 [X + |X|], implies
(A(t) + B(t))+ = max{A(t) + C(t), 0}
1
= [A(t) + C(t) + |A(t) + C(t)|].
2
and since
||A(t)| |C(t)|| |A(t) + C(t)| |A(t)| + |C(t)|

27

we see that
A(t) + C(t) + ||A(t)| |C(t)|| A(t) + C(t) + |A(t) + C(t)|
(22)
A(t) + C(t) + |A(t)| + |C(t)|
Moreover,




E [||A(t)| |C(t)||] = E (|A(t)| |C(t)|)1{|A||C|} + E (|C(t)| |A(t)|)1{|C|>|A|}
|E[|A(t)|] E[|C(t)|]|

and according to this taking expectations in equation (22) gives

EA(t) + EC(t) + |E|A(t)| E|C(t)|| 2E[(A(t) + B(t))+ ]


2([E[A(t)+ ] + E[C(t)+ ])
and the result follows.

Proof of Theorem 5
Assuming independence between interest rate and spread, we have.
h Ti e
i
D(t, Ti ) = Et e t rs +t,T ds
h Ti e i h Ti
i
t rs ds
t t,T ds
= Et e
Et e


= B e (t, Ti )Et e(Ti t)t,T ,
h T
i
i e
where B e (t, Ti ) = Et e t rs ds .

28

(23)

Because Ti1 ,Ti and D(t, Ti ) are non-negative, we have

E[A(t)] =
E[A(t)+ ] =
E[A(t) ] =
E[|A(t)|] =

n
X
i=j
n
X
i=j
n
X
i=j
n
X

E[Ai (t)]
E[Ai (t)+ ]
E[Ai (t) ]
E[|Ai (t)|]

i=j

Furthermore, under the assumption that r and are independent, we have




E[Ai (t)] = Bt,T,i E (t,T 0,T )Et e(Ti t)t,T ,

(24)




E[Ai (t)+ ] = Bt,T,i E (t,T 0,T )+ Et e(Ti t)t,T

(25)




E[Ai (t) ] = Bt,T,i E (t,T 0,T ) Et e(Ti t)t,T

(26)

h T
i
i e
where Bt,T,i = Ti1 ,Ti E e t rs ds . We see this simply by calculating

+ i
(t,T 0,T )Ti1 ,Ti D(t, Ti )
h Ti e i h
h Ti
ii
= Ti1 ,Ti E e t rs ds E (t,T 0,T )+ Et e t t,T ds .

E[Ai (t)+ ] = E

(27)

Formulas for (24) and (26) essentially follow from this. Furthermore

E[|A(t)|] = E[A(t)+ ] + E[A(t) ].

29

(28)

Equation (23) and Lemma 7 with change of variable z =

x( (Ti t)

yields





E (t,T 0,T )+ D(t, Ti ) = B(t, Ti )E (t,T 0,T )+ e(Ti t)t,T

(t,T 0,T )e(Ti t)t,T dP(t,T )
= B(t, Ti )
0,T

(x 0,T )e(Ti t)x e

= B(t, Ti )

(x )2
2

0,T

= B(t, Ti )e(Ti t) +

where d =

0,T ( (Ti t) )

.
2

(Ti t)2
2

dx
2

[ N 0 (d) + ( (Ti t) 0,T )(1 N (d))] ,

This concludes the proof of (25). Changing the integration limits

in the obvious way we get (24) and we also see that

E[Ai (t) ] = Bt,T,i C,i [ N 0 (d) ( (Ti t) 0,T )N (d)] .

Finally, the result follows from (28).


Lemma 7 Suppose X N (, ) and A . Then for all , , we have that

X+

X e

1A dPX = e



2 2
+ 2 +

z2
dz
(z + + 2 ) e 2 1A .
2

Proof. We have that

X+

X e

1A dPX =

x ex+ e

30

dx
2

1A



(x)2

x
2

x e

(x)2
2 2

dx
2

1A

(29)

and since

(x )2
1
2
2
2
x

2x
+

2
x

=
2 2
2 2

1
= 2 x2 2( + 2 )x + 2
2

1
= 2 x2 2( + 2 )x + ( 2 )2 2 2 4 2
2

1
2 2
+
x2 2( + 2 )x + ( + 2 )2
=
2
2
we have


X+

X e

1A dPX = e

2 2
2


+

x e

x(+ 2 )

(x(+ 2 ))2
2 2

Now change of variable z =

dx
.
2

1A

gives the result.

FX Call
We show how to get values for E [max{C(t), 0}] from volatility data. Suppose we know the
Black-Scholes volatility BS . Then


St = S0 e

r$ (re +)

2
BS
2


t+BS Wt

where r$ , re , and BS are constants. Now




2
(r$ (re +)t BS
t+
W
t
BS
2

S0
C(t) =
1=
St

(re +)t

=e

r$ t

2
BS
2

tBS tZ

!
1

(re +)t

where Z follows the standard normal distribution. Clearly C(t) is positive whenever

2
$
(re + + BS

r
)
t
2
Z d2 :=
BS

31

and using Lemma 7 we obtain

E [max{C(t), 0}] = e

(re +)t

d1

r$ t

2
BS
2

tBS tZ

(re +)t


dPZ

=e

(re +)t

2 )t
(r$ +BS

N (d1 ) e

(re +)t


N (d2 ) ,

where d1 = d2 + BS t. Notice that this differs from the traditional Black-Scholes price a little
due to the Siegels paradox [6].

32