The Basis Goes Stochastic: A Jump-Diusion Model

for Financial Risk Applications

Minqiang Li and Fabio Mercurio
August 23, 2016

Abstract
There are several pricing and risk model applications where the assumption of
a deterministic LIBOR-OIS basis can lead to severe mispricing. By modeling such
a basis using a jump-diusion process, we show how stochastic basis can impact
the valuation of specic deals such as zero-coupon swaps, as well as credit valuation
adjustments and gap risk in particular. Explicit formulas are provided and numerical
examples showcased.

Introduction

Many current applications of nancial modeling, ranging from derivatives pricing to risk
management practices, rely on the assumption that the LIBOR-OIS basis is deterministic.
Assuming a deterministic basis is not unrealistic: basis spreads were virtually constant
before the 2007 credit crunch, and still tend to be relatively stable in the absence of market
turbulence. It is also very convenient: upgrading a single-curve interest-rate model to a
multi-curve framework, where four or more curves need to be modeled jointly, is an easier
task when postulating a single driving curve, with the others being built deterministically
on top of this one. Furthermore, many interest-rate derivatives do not seem to depend
signicantly on the volatility of the basis, nor on its correlation with LIBOR or OIS curves.
However, there are instances where the stochastic behavior of the LIBOR-OIS basis
impacts valuations, for example: i) the pricing of specic deals such as cash-settled swaptions or zero-coupon swaps; ii) the generation of multi-curve scenarios for stress testing and
risk-management purposes; iii) the credit valuation adjustment (CVA) modeling of deals
such as intra-currency basis swaps; iv) the pricing of wrong-way-risk (WWR) or gap risk
for generic interest-rate deals, and vanilla swaps in particular. In all these cases, modeling
stochastic basis spreads is crucial to avoid inconsistencies or obvious mispricing of risks.

Quant Analytics, Bloomberg LP. E-mails: mli159@bloomberg.net, fmercurio@bloomberg.net. We

thank two anonymous referees for their comments and insights. The contents of this article represent the
authors views only, and do not represent the opinions of any rm or institution.

1
Electronic copy available at: http://ssrn.com/abstract=2827769

The LIBOR-OIS basis can be modeled directly by assuming some specic dynamics, or
indirectly by modeling the evolution of LIBOR and OIS curves separately. In this article,
we follow the former approach and model the LIBOR-OIS basis directly and consistently
with historical behavior. This allows us to focus on the dominant risk factor driving
specic valuations, and also gives us the advantage of a parsimonious framework, where
no modeling of OIS and LIBOR rates is needed. In fact, in our numerical examples below,
no factor other than the basis has to be modeled as stochastic.1
We model the LIBOR-OIS basis for a given tenor as a simple jump-diusion process.
We then consider the particular cases of: i) a mean-reverting diusion to price deals that
depend on basis volatility; ii) a pure-jump dynamics to quantify gap risk in CVA modeling.
Specic examples of the pricing of a zero-coupon swap (ZCS) and the gap risk of a vanilla
interest-rate swap will be showcased.
Basis models have been proposed by Piterbarg (2010), Mercurio (2010) and Mercurio
and Xie (2012) for pricing derivatives in a multi-curve framework and by Mercurio and
Li (2015) for assessing WWR of interest-rate derivative portfolios. The approach we use
in this article is dierent. We directly model the spot basis as opposed to forward bases.
Thanks to this, we are able to specify general basis dynamics that are consistent with
historical data, and propose specic approaches for the valuations of ZCS and swap gap
risk.

Denitions and notation

We use a notation similar to that of Mercurio and Li (2015). We denote by PD (t, T ) the
discount factor at time t with maturity T calculated o the OIS curve (the subscript D
stands for discount). We assume that the pricing measures are dened by the OIS curve.
We denote by Q the OIS
 t risk-neutral measure with associated expectation operator E and
numeraire B(t) = exp{ 0 r(u) du}, where r denotes the OIS instantaneous spot rate, and
by QT the OIS T -forward measure with associated expectation operator ET and numeraire
PD (, T ).
We x a tenor x (e.g. x = 3 months), and denote by L(t, T ) and F (t, T ), respectively,
the x-forward LIBOR and the x-OIS forward rate at time t for the interval [T, T + x]. The
x-LIBOR and x-OIS spot rates are denoted and dened, respectively, by L(t) := L(t, t)
and F (t) := F (t, t). By denition:


1
PD (t, T )
F (t, T ) :=
1
x PD (t, T + x)
(1)


T +x
L(T )|Ft
L(t, T ) := E
where Ft is the sigma-algebra generated by the relevant risk factors up to time t.
The LIBOR-OIS forward basis can be dened in an additive or a multiplicative way:
1
Our purpose is not necessarily to develop a new multi-curve model. Instead, we want to consider
pricing applications where the LIBOR-OIS basis is the main risk factor, which can be modeled directly
without modeling OIS or LIBOR rates (provided we assume independence between OIS and basis).

2
Electronic copy available at: http://ssrn.com/abstract=2827769

 Additive:

B(t, T ) = B A (t, T ) := L(t, T ) F (t, T )

Multiplicative:
B(t, T ) = B M (t, T ) :=
so

B A (t, T )
1 + xF (t, T )

[1 + xB M (t, T )][1 + xF (t, T )] = 1 + xL(t, T )

The time-0 forward basis spreads B A (0, T ) and B M (0, T ), T 0, can be inferred from
time-0 term structures of forward LIBOR and OIS rates.
The LIBOR-OIS spot basis is denoted and dened by B(t) := B(t, t). Likewise, we set
B A (t) := B A (t, t) and B M (t) := B M (t, t).2
Since F (t, T ) and L(t, T ) are martingales under QT +x , the additive basis B A (t, T ) is a
QT +x -martingale as well, so


B A (t, T ) = ET +x B A (T )|Ft
(2)
Instead, it is easy to show that the multiplicative basis B M (t, T ) is a QT -martingale, that
is:


(3)
B M (t, T ) = ET B M (T )|Ft
Additive and multiplicative bases coincide at rst order on rates, so they tend to be very
similar if OIS rates are not too large. Modeling one or the other, however, can present
dierent advantages or challenges. The choice of which basis is more convenient to model
is driven by the specic application, as we also show in our examples below.

The basis dynamics

We propose a model of spot basis dynamics that is consistent with historical behavior and
stylized facts. We rst list the main features of basis dynamics that are visible in historical
patterns. Then, we propose a model that accommodates most of these features, at the
same time allowing for simple analytical or numerical calculations.

3.1

Historical features

Since August 2007, the LIBOR-OIS basis in major currencies showed unprecedented behavior, and has consistently been evolving stochastically. Inspecting historical data, see
Fig. 1, we can identify the following properties for basis dynamics:
Positivity: there is a positive premium embedded in the basis, which comes from
LIBOR funding being unsecured.3
2

One can also dene instantaneous basis spreads as in Andersen and Piterbarg (2010). Modeling a
nite basis is, however, more realistic. It is also easier to model and implement in the specic cases we are

0.55

1.4

0.48

1.2

0.41

0.34

0.8

0.27

0.6

0.2

0.4

0.13

0.2

1/4/2011

7/2/2013

0
1/4/2011

1/1/2016

7/2/2013

1/1/2016

Figure 1: The USD 3-month LIBOR-OIS basis (left), and the EUR 6-month LIBOR-OIS
basis (right) from January 2011 to January 2016 (in %).
A piece-wise diusion: the LIBOR-OIS basis tends to behave like a (continuous)
diusion process in time periods where no negative news hits the market.
Regime switches: events such as a large institutions default or a countrys downgrade
cause market turmoil and dene a new regime with higher costs of funding for the
interbank system. Short-term basis jumps and its volatility soars.
Mean-reversion: LIBOR is, by construction, a trimmed average. If the credit worthiness of a panel bank deteriorates signicantly, then such a bank will no longer
contribute to the denition of this average. In the longer term, this bank may be
replaced by a bank with a better credit quality, thus improving the overall credit
quality of the panel. The mean-reverting behavior can also be inferred from forward
basis, which is a risk-adjusted average of future spot basis, and tends to be much
more stable in the long end than in the short end of the curve.

3.2

The proposed model

We propose a minimal model framework that incorporates the historical features above in
a single dynamics, while at the same time being general enough to cover the two specic
pricing applications we will consider in the next sections.
We assume that spot basis B(t) evolves in the OIS risk-neutral measure Q according
to the following jump-diusion model:


B(t) = f X(t) + (t) + (t)
(4)
dealing with in this article.
3
Recently, the EUR one-month LIBOR-OIS basis ventured in negative territory. This could still be
regarded as an exception not altering the overall picture. That said, our basis dynamics below can also
accommodate negative basis values.

where
The basis B can be either additive, that is B(t) = B A (t), or multiplicative, that is
B(t) = B M (t);
f is a real function that allows for the closed-form calculation of forward basis. We
choose f to be the identity or the exponential function;4
X is a Gaussian (OU) process mean-reverting to zero:
dX(t) = kX(t) dt + dW (t)

(5)

with X(0) = 0, and where k and are positive constants and W is a standard
Q-Brownian motion;
is a deterministic function that is used to calibrate the initial term structure of
forward basis spreads B(0, T ), T 0;
is a (compensated) pure-jump process that jumps only once at a random time
and is independent of W :
t
J(u, t) du + J(, t)1{ t}
(6)
(t) =
0

where J is a deterministic jump size that depends both on and running time t, and
is exponentially distributed with parameter .5 We refer to Appendix C for details
on the process (6).
The proposed basis dynamics can be explained as follows. Process B is the sum of
a mean-reverting diusion process, which is Gaussian if f is the identity and lognormal
is f is the exponential function,6 and a pure single-jump process, which is deterministic
before and after the jump time . The jump component is zero on average at time zero,
but its long-term behavior depends, in general, on the specication of J. Typical choices
of J preserves mean-reversion also at future times, but the mean-reversion level is in
general path-dependent. A notable exception is given by exponentially-decreasing jumps,
see Appendix C. In this case, process B always mean reverts to the same initial meanreversion level, regardless of the jump time.
Remark 3.1 (Possible extensions). Dynamics (4) could be extended by including multiple
jumps even with random size, or regime-switching parameters k and , whose value would
change after a jump, or a time-dependent (or even stochastic) intensity . Dynamics could
also be modied, for instance, by considering a dierent function f or a dierent process
4
Typically, we choose f (z) = exp(z) to enforce positivity of basis spreads in the vast majority of
paths (there is still a chance that brings B in negative territory). Instead, we choose f (z) = z when
we are willing to relax the positivity constraint in exchange for obvious gains in tractability and ease of
implementation.
5
The reason for introducing an extra time dependence in J is to allow for a more general term structure
of forward basis jumps, see Section 6 below.
6
Precisely, we get the Hull-White (1990) model in the former case, and the Black-Karasinski (1991)
model in the latter.

X, or by moving the jump component inside function f . However, (4) is general enough
for many practical purposes, including our examples below.
Remark 3.2 (Multi-tenor modeling). In this article we are focusing on a single tenor x.
Modeling basis spreads for multiple tenors is, in general, a more complex task to accomplish. One must ensure there is a positive spread also between dierent LIBOR curves, by
imposing inequalities such as:
[1 + xLx (t, T )][1 + xLx (t, T + x)] 1 + 2xL2x (t, T )
or, equivalently,
[1 + xB x,M (t, T )][1 + xB x,M (t, T + x)] < 1 + 2xB 2x,M (t, T )
where we introduced superscripts x and 2x to highlight dependence on the corresponding
tenor.
Given a basis denition and a model dynamics, these inequalities may not be satised for
all times and states of the world. Small violations, however, could be acceptable depending
on the considered application.

Model parameter calibration

Integrating (5) leads to



t

k(tu)
e
dW (u) + (t)
B(t) = f
0

J(u, t) du + J(, t)1{ t}

(7)

where f (z) = z or f (z) = exp(z).

Stochastic basis parameters are typically hard to calibrate because of the absence of
market quotes for LIBOR-OIS basis options or OIS caps and swaptions. Most of the
parameters in (7), therefore, must be calibrated historically or determined based on fundamental analysis. For instance, diusion parameters k and could be calibrated using
a Maximum Likelihood Estimation (MLE), whereas function J could be dened by the
average size and typical shape of historical jumps of spot and forward bases.7

4.1

Calibration of

Function is to be calibrated to time-0 forward basis spreads B(0, T ), T 0. Let us

assume independence of W and OIS rates. This implies that basis dynamics under a
forward measure are the same as those under Q, so B(0, T ) = E[B(T )] both for additive
and multiplicative basis. We thus get:
 



 

E[B(T )] = E f X(t) + (t) + E (T ) = E f X(t) + (t)
(8)
7
In the gap risk section below, the jump function J will be chosen to be positive and exponentially
decreasing.

since the expected value of is zero. The calibrated value of (t) depends on the specication of f . If f (z) = z, we have:


B(0, T ) = E X(T ) + (T ) = (T )
(9)
because also the expected value of X(T ) is zero. Instead, if f (z) = exp(z), we have:


B(0, T ) = E exp{X(T ) + (T )}

(10)

2 
1 e2kT
= exp (T ) +
4k
so that

2 
1 e2kT
(11)
(T ) = ln[B(0, T )]
4k
The case of non-zero correlation between basis and OIS rates can also be solved explicitly, for instance when the OIS rate r follows a one-factor Hull and White (1990) model.
We refer to Appendix A for related calculations.

The pure diusion case

When pricing derivatives, jumps are typically introduced to calibrate short-term skews, or
to model instantaneous devaluations caused by market turmoil, downgrades or defaults.
Though realistic, jumps are however problematic to calibrate, simulate and hedge, so they
tend to be neglected in most practical applications. Therefore, we rst focus on the pure
diusion case, which is obtained by removing the jump component, or equivalently by
setting J 0 in (7):


B(t) = f

ek(tu) dW (u) + (t)

(12)

where (t) is given either by (9) or (11) depending on whether f is the identity or the
exponential function.

5.1

Application: the pricing of a ZCS

A ZCS is a swap where xed and oating payments are exchanged at the swaps maturity.
Denoting by T0 := 0, T1 , . . . , TN 1 the oating-legs xing times, where Tj Tj1 = x for
j = 1, . . . , N, the ZCS oating leg pays at maturity TN :
N

[1 + xj L(Tj1 )] 1

(13)

j=1

where we assume a unit notional, and xj is the year fraction for the interval (Tj1, Tj ].

:
Instead, the ZCS xed leg pays at TM
M

[1 + xi K] 1
i=1

(14)




where T0 := 0, T1 , . . . , TM
1 are the xed-legs xing times, with TM = TN , and xi denotes
the corresponding year fraction.
The valuation of the xed leg is straightforward, and equal to (14) multiplied by the

discount factor PD (0, TM
) = PD (0, TN ):

fixed

M

(0; TN ) = PD (0, TN ) [1 + xi K] PD (0, TN )

(15)

i=1

The valuation of the oating leg requires more attention, and is outlined as follows.
A convenient measure for valuation purposes is the spot-OIS whose associated numeraire is the discretely-rebalanced OIS bank account, rolling on dates T1 , . . . , TN 1 .8 The
ZCS oating-legs value at time 0 can then be written as:

 N
[1
+
x
L(T
)]
j
j1
j=1
V float (0; TN ) = ESO N
PD (0, TN )
j=1 [1 + xj F (Tj1 )]

N
(16)

[1 + xj B M (Tj1 )] PD (0, TN )
= ESO
j=1

where ESO denotes expectation under the given spot-OIS measure. Assuming a deterministic (multiplicative) basis leads to the following model-independent formula:
V

float

N

(0; TN ) =
[1 + xj B M (0, Tj1)] PD (0, TN )

(17)

j=1

However, as is clear from Eq. (16), a ZCS is eectively a non-linear contract on the
multiplicative basis. Modeling such a basis as a stochastic process, with non-zero volatility,
can lead to signicant pricing corrections, as shown in the following section. See also the
recent Risk article by Becker (2015).
The ZCS rate for maturity TN is dened as the unique value of K such that the ZCS
has zero value at time 0, that is
V fixed (0; TN ) = V float (0; TN )
Assuming, for simplicity, the same xing times for both legs and constant year fractions
xj = x, the ZCS rate K = KN is given by
1/N

1 V float (0; TN )
1
+1

KN =
x PD (0, TN )
x
8

(18)

In the single-curve model literature this measure is typically referred to as spot-LIBOR. We here
coined the term spot-OIS to stress dependence on the OIS curve.

5.2

Numerical example

We assume, for simplicity, that function f is the identity, and that multiplicative basis
B M (t) is independent of OIS rates. We refer to Appendix B for a discussion on the
exponential function case. Basis dynamics in the spot-OIS measure is the same as that
under Q, that is:
B M (t) = X(t) + B M (0, t)
where we used Eq. (9).
Process B M (t) is easy to simulate: X(Tj ) conditional on X(Tj1 ) is normally distributed
with conditional mean and variance given by
E[X(Tj )|X(Tj1)] = X(Tj1 ) ek(Tj Tj1 )
(19)

2 
1 e2k(Tj Tj1 )
Var[X(Tj )|X(Tj1)] =
2k
In our numerical example, we value ZCSs with semi-annual xing times and semi-annually
spaced maturities from 1 to 30 years. We use OIS and LIBOR curves data for the EUR
market as of 12/31/2015, see Figure 2, where the LIBOR curve has been stripped by maximizing smoothness of the basis. We set k = 0.15, = 0.01, and x = 0.5. We calculate ZCS
2.5
0.25
2
0.2
1.5
0.15

0.1

0.5

0.05

0
OIS
LIBOR
0.5
0

10

20

0
0

30

10

20

30

Figure 2: EUR semi-annual forward LIBOR and forward OIS rates (in %) as of 12/31/2015
(left). Implied LIBOR-OIS forward basis spreads (in bp) (right).
rates Ki = KiOU , using a Monte Carlo simulation of OU basis dynamics, and ZCS rates
Ki = Kidet obtained using the deterministic-basis formula (17), for Ti = 1, 1.5, 2, . . . , 30
years. The dierence between ZCS rates KiOU and Kidet is referred to as convexity adjustment for maturity Ti . Results are shown in Figure 3, where we compare ZCS rates Kidet and
KiOU , for maturities Ti = 1, 1.5, 2, . . . , 30 years, and show the corresponding convexity adjustments. We observe that the impact of basis volatility is negligible for short maturities
but it becomes increasingly material for longer maturities.9
9

One may argue that a volatility = 0.01 is too large compared to historical values. Using a MLE

0.16
0.14

1.5
0.12
0.1

0.08

0.5

0.06
0.04

0
0.02

Deterministic basis
Stochastic basis
0.5
0

10

15

20

25

0
0

30

10

20

30

Figure 3: Comparison between ZCS rates Ki obtained from the deterministic-basis formula
(17) and the ZCS rates Ki calculated using MC and OU basis dynamics (left). The implied
convexity adjustments (right).

The pure jump case

The pure jump case is obtained by removing the diusion process X from the basis dynamics, or equivalently by setting = 0 in (7).
Assuming that the function f is the identity, and using Eq. (9), we have:
t
B(t) = B(0, t)
J(u, t) du + J(, t)1{ t}
0

t
(20)
0 J(u, t) du
if t <

= B(0, t) +
if t
0 J(u, t) du + J(, t)
Basis B evolves deterministically until time , it jumps by the amount J(t, t) at t = , and
evolves deterministically also after time .
Forward basis spreads at a generic time t can be obtained by using the martingale
property (2) of additive basis, or (3) for the multiplicative basis, and the independence
between and OIS rates. We get:
t
B(t, T ) = B(0, T )
J(u, T ) du + J(, T )1{ t}
0

t
(21)
0 J(u, T ) du
if t <

= B(0, T ) +
0 J(u, T ) du + J(, T )
if t
estimate based on historical data from 1/2/2006 to 12/31/2015, in fact, we get = 0.0038, which leads
to a convexity correction of 2 bp per annum for the 30y ZCS rate, which is in line with market quotes.
In this example, we chose a higher to show more clearly the potential impact of stochastic basis in the
valuation of a ZCS.

10

which is a generalization of the forward basis model proposed by Mercurio and Li (2015).
We notice that B(t, T ), for any given T , is deterministically decreasing before time , and
constant thereafter. The jump size is equal to J(, T ), and depends both on the jump time
and the basis maturity. This allows us to model non-at term structures of forward basis
jumps. We can therefore enforce consistency with historical behavior of the basis, which
tends to jump more in the short end than the long end of the curve.

6.1

Application: the pricing of gap risk

Gap risk occurs in CVA calculations under collateralization because of the potentially material dierences (typically at default) between mark-to-market portfolio value and value
of the existing collateral. These dierences can arise because of the time lag (called margin
period of risk) between the actual close-out date and the date of the last collateral payment.10 They can also arise when the margin period of risk is zero but risk factors jump at
counterpartys default. We here deal with the latter case, and assume that: i) the margin
period of risk is zero; ii) the LIBOR-OIS basis jumps at counterpartys default.11 To this
end, we use dynamics (20), and assume that is the default time of a given counterparty,
and that jumps are positive.
Modeling a positive basis jump at default is realistic when the counterparty is a
sovereign or supranational entity or a big enough corporation or nancial institution.12
However, since default and jump are modeled as simultaneous events, our approach also
covers the case of a counterparty that can go bust because of a sudden increase of the
borrowing rates. For more general counterparties, a jumping basis model could still be
used as an approximation of real dynamics. For instance, a single jump value can be dened so as to summarize a signicant value change (either upwards or downwards), which
could happen on a larger time scale, say a few weeks, because of rates volatility. This
interpretation allows us to calculate gap risk also for deals with negative basis delta, since,
mathematically, our approach works also with negative jumps sizes.13
In the following, we focus on the single-currency case for simplicity. This allows us
to derive a simple explicit formula for the gap risk of a standard interest rate swap. An
extension to the multi-currency case is possible, for instance, by adding jump-at-default FX
dynamics as in Mercurio and Li (2015). In the case of a single cross-currency swap portfolio,
we can still obtain a simple gap risk formula, provided that we assume deterministic interest
rates, which is acceptable since most of the deal exposure is driven by FX rate volatility.
10

In practice the margin period of risk is one to two weeks.

When compared with a diusion component, the jump tends to dominate and accounts for most of
a factors variability in the margin period of risk. Moreover, when factors jump at default, reducing the
margin period of risk to zero has little impact in gap risk calculations.
12
Think, for instance, of Lehmans default, which triggered a signicant upward jump in the basis.
13
If we want to ensure that the basis remains positive, we should model a multiplicative jump, which
would lead to a more involved pricing formula.
11

11

6.2

Application: gap risk of an interest-rate swap

Let us consider a payer interest rate swap, where we receive LIBOR and pay a xed rate,
and whose oating leg pays (in arrears) at times Tk , k = 1, . . . , N, the x-LIBOR, which is
set (in advance) at Tk1 , where Tk Tk1 = x, and T0 := 0.
The unilateral CVA of this swap is dened by the following standard formula:
TN


CVA = (1 R)
E D(0, t)(V (t) C(t))+ | = t f (t) dt
(22)
0

where R is the assumed-constant recoveryrate, D(0, t) is the OIS stochastic discount factor
t
for maturity t, that is D(0, t) = exp{ 0 r(u) du}, V (t) and C(t) are, respectively, the
swaps and collaterals mark-to-market values at time t, and f denotes the risk-neutral
density of default time .
We assume full collateralization, that is C(t) = V (t), and collateral re-hypothecation.
Conditional on default happening at time t, the dierence V (t) V (t) represents the
instantaneous change of swaps value caused by default. Since OIS rates are not aected
by default, the xed-legs value is continuous at t, so the dierence V (t)V (t) comes from
changes in value of the oating leg, and precisely from changes in forward basis spreads.
From Eq. (21), we see that the basis with maturity Tk jumps by J(t, Tk ). Therefore, the
dierence V (t) V (t) is given by:
N
1


V (t) V (t) =

J(t, Tk )PD (t, Tk+1 ) > 0

(23)

k=(t)

where (t) is the index of the next payment time after t.14 Therefore,

TN
N
1

E D(0, t)
J(t, Tk )PD (t, Tk+1 )| = t f (t) dt
CVA = (1 R)
0

= (1 R)
= (1 R)
= (1 R)

N
1 Tj+1

j=0

Tj

j=0

Tj

N
1


E D(0, t)

N
1 Tj+1 N
1



N
1 N
1



k=(t)


J(t, Tk )PD (t, Tk+1) f (t) dt

k=j+1

(24)

J(t, Tk )PD (0, Tk+1 ) f (t) dt

k=j+1

PD (0, Tk+1)

j=0 k=j+1

Tj+1

Tj

J(t, Tk ) f (t) dt

Gap risk under our pure-jump basis model is thus extremely simple to calculate. We
notice it is the same for all swaps with same notional and payment times, irrespective of
their xed rate. It is also insensitive to the initial term structure of basis spreads.
14
Notice that gap risk occurs irrespective of the swaps mark-to-market value, even when V is negative.
In this case, in fact, we posted more collateral than necessary, and the excess collateral will not be returned
by the defaulting party.

12

6.3

Numerical example

We assume a constant OIS rate r and an exponentially decreasing jump size, that is
J(t, T ) = hea(T t)
where h and a are positive constants. The gap-risk formula (24) then simplies to:
Tj+1
N
1 N
1


rTk+1
e
ea(Tk t) et dt
CVA = (1 R)h
Tj

j=0 k=j+1
rx

= (1 R)he

1
N
1 N



(r+a)Tk

e(a)t dt

N
1 N
1


j=0

= (1 R)h

Tj+1
Tj

j=0 k=j+1

= (1 R)herx

[e(a)Tj+1 e(a)Tj ]
e(r+a)Tk
a

k=j+1

(25)

N
1
N
1


rx (a)x
1]
e(a)Tj
e(r+a)Tk
e [e
a
j=0
k=j+1

where we assume a = . Writing the last two sums in closed form, after some simplication
we nally get:


1 e(r+a)TN
herx 1 e(r+)TN

(26)
CVA = (1 R)
a 1 e(r+)x
1 e(r+a)x
We then set R = 40%, x = 0.5, TN = 10 years, r = 1% and a = 0.1, and calculate gap
risk for dierent values of and h. Results are shown in Table 1, where we conrm that
gap risk is linear in h and proportional to . Gap risk can have a signicant impact on
the swaps valuation. For instance, for a short-term basis jump of 50 bp and an intensity
= 1%, it is roughly 0.2% of the swaps notional.
h\
0.001
0.002
0.003
0.004
0.005

0.01
0.0382
0.0763
0.1145
0.1526
0.1908

0.02
0.0738
0.1475
0.2213
0.2951
0.3688

0.03
0.1070
0.2141
0.3211
0.4281
0.5352

0.04
0.1381
0.2762
0.4143
0.5524
0.6906

0.05
0.1672
0.3343
0.5015
0.6687
0.8358

Table 1: Gap risk from Eq. (25). Values are in % of swaps notional.

Conclusions

Despite that LIBOR-OIS basis has been evolving randomly since the 2007 credit crunch,
pricing applications widely rely on the assumption of deterministic spreads. While this is
13

acceptable in most cases, there are instances where basis volatility has a material impact.
In this article, we model the LIBOR-OIS basis consistently with historical patterns, and
present two specic pricing applications, one on the valuation of a ZCS, the other on the
valuation of swap gap risk.
We focused on the single tenor case. Extensions to the multi-tenor case are straightforward, but enforcing stylized features, such as positivity, across dierent tenors may be
challenging.
Modeling cross-currency basis is a completely dierent task. Not only is the modeling
task more complex because of the presence of multiple currencies, but it is also harder to
dene stylized features of basis behavior suggesting specic dynamics.

References
[1] Andersen, L. and Piterbarg, V. (2010) Interest Rate Modeling, in Three Volumes.
Atlantic Financial Press.
[2] Becker, L. (2015). Zero intolerance, Risk October, 23-25
[3] Black, F., Karasinski, P. (1991) Bond and Option Pricing when Short Rates are Lognormal. Financial Analysts Journal 47, 52-59.
[4] Brigo, D., and Mercurio, F. (2006). Interest-Rate Models: Theory and Practice. With
Smile, Ination and Credit. Springer Finance.
[5] Hull, J., White, A. (1990). Pricing interest-rate-derivative securities. Review of nancial studies 3(4), 573-592.
[6] Li, M., Mercurio, F. (2015). Jump-at-default modeling of wrong-way risk for credit
value adjustment.
Available online at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2605648
[7] Mercurio, F. (2010). A Libor market model with a stochastic basis. Risk December,
96-101.
[8] Mercurio F., and Li. M. (2015). Jumping with Default: Wrong-Way Risk Modeling
for CVA, Risk November, 58-63.
[9] Mercurio, F., Xie, Z. (2012). The basis goes stochastic, Risk December, 78-83.
[10] Piterbarg, V. (2010). Funding Beyond Discounting: Collateral Agreements and
Derivatives Pricing, Risk February, 97-102.

14

Appendix: The case of non-zero correlation between basis and OIS rates

We assume that the instantaneous OIS rate r follows a simplied version of the Hull-White
(1990) one-factor model with constant mean-reversion speed and volatility:
r(t) = y(t) + (t)
dy(t) = by(t) dt + dZ(t)
where b and are positive constants, and is a deterministic function calibrated to the
time-0 OIS curve. The dynamics of X under the OIS T -forward measure can be derived
using classic measure-change techniques, see for instance Brigo and Mercurio (2006). We
get:


1 eb(T t)
dX(t) =
kX(t) dt + dW T (t)
(27)
b
where is the instantaneous correlation between W and Z, and W T is a standard QT Brownian motion. Straightforward algebra leads to:


 1 ekT
1 e(k+b)T 
ET X(T ) =

b
k
k+b

(28)

Assuming that function f is the identity and that the basis is multiplicative, we have, see
Eq. (3):




B M (0, T ) = ET B M (T ) = ET X(T ) + (T )
so that, using Eq. (28),
(T ) = B M (0, T ) +

1 e(k+b)T 
 1 ekT

b
k
k+b

(29)

Appendix: ZCS pricing when the basis is lognormal

Let us a assume that f is the exponential function, so dynamics (12) for the multiplicative
basis becomes:

 t

2 
M
M
k(tu)
2kt
1e
B (t) = B (0, t) exp
e
dW (u)
4k
0


(30)


1
M
= B (0, t) exp X(t) Var X(t)
2
where we used (11) and the denition of process X.

15

Under (30), the expectation in (16) can be calculated in closed form. We rst notice
that for any real vector (c1 , . . . , cN ), we can write:
N
N
N
1 
N



[1 + cj ] = 1 +
ci +
ci cj + . . .
j=1

i=1

=1+

i=1 j=i+1

N N
r+2
r+1 N

k=1

i1 =1 i2 =i1 +1

N


k


(31)
c ij

ik =ik1 +1 j=1

so

N
N N
r+2
r+1 N


M
[1 + xj B (Tj1 )] = 1 +

E
j=1

k=1

i1 =1 i2 =i1 +1

N

ik =ik1 +1

 k



xij B M (Tij 1 )

(32)

j=1

Then, we apply (30) and calculate the expectation in the RHS of the last equation as
follows:

 k

 k

 
k



1
xij B M (Tij 1 ) =
xij B M (0, Tij 1 ) exp Var[X(Tij 1 )] E exp
X(Tij 1 )
E
2
j=1
j=1
j=1
(33)
Since the exponent of the last exponential is normally distributed, and E[exp(X)] =
exp[Var(X)/2] for a normal random variable X with zero mean, we get:
 k



k


1
M
M
E
xij B (Tij 1 ) =
xij B (0, Tij 1 ) exp Var[X(Tij 1 )]
2
j=1
j=1
 k

k1 
k
 


 
 
1
Var X(Tij 1 ) +
E X Tij 1 X Tih 1
exp
2 j=1
j=1 h=j+1
 k1 k

k

   



=
xij B M (0, Tij 1 ) exp
E X Tij 1 X Tih 1
j=1

j=1 h=j+1

(34)
The nal step is the calculation of the expected value on the RHS of (34):
 

 

 

 
E X Tij 1 X Tih 1 = E X 2 Tij 1 exp k Tih 1 Tij 1

 

 
= Var X Tij 1 exp k Tih 1 Tij 1


 

2 
(35)
1 exp 2kTij 1 exp k Tih 1 Tij 1
=
2k
 

 

2 
exp k Tih 1 Tij 1 exp k Tih 1 + Tij 1
=
2k
16

Plugging (35) into (34) and (34) into (32) yields the desired formula. An approximation
to this formula can be obtained by truncating the rst sum in (32) at some level n < N,
thus only calculating terms that involve multiplication of at most n coecients.15
We mention that another advantage of the lognormal assumption is that it can lead to
realistic and humped term structures of forward basis even in the Exponential-Vasicek
time-homogeneous case, where in (12) is set to be a specic function of k, B(0) and a
mean reversion parameter .

Appendix: The jump process

Given the Poisson process N with constant intensity , let us dene the compensated
pure-jump process by:
t
(t) =
J(u, t)1{ u}[dN(u) du]
(36)
0

where J(u, t) is a deterministic jump size and is the rst jump time of N. By construction,
jumps only once at time , since the indicator function in (36) kills all the jumps after
the rst one.
By denition of Poisson stochastic integral, can be expressed as follows:16
t
(t) =
J(u, t) du + J(, t)1{ t}
(37)
0

The behavior of the jump process can be described as follows. It evolves deterministically
until time , jumps by the amount J(t, t) at t = , and then evolves deterministically after
time .
A typical choice of J consistent with historical observations is
J(t, T ) = hea(T t)
for some positive h and a, meaning that for a given t, the jump size is a function of T
exponentially decreasing to zero. Plugging this expression into (37), we get:
t
(t) = h
ea(tu) du + hea(t ) 1{ t}
 0 t

(38)
at
au
a
=e
e du + he 1{ t}
h
at

=: e

M(t)

15

In fact, the approximation is a lower bound because the coecients cij are all positive.
The use of a Poisson process is merely instrumental. In fact, it would be enough to introduce a random
time , exponentially distributed with parameter , and dene the compensator of process J(, t)1{ t} .
16

17

where the last equality denes the martingale process M, that is:

 a(t )

h
e

1
+ hea 1{ t} if a > 0
a
M(t) =
h(t ) + h1{ t}
if a = 0

(39)

Therefore, for this choice of exponentially decreasing jumps, process is obtained by

deating a path-wise bounded martingale, and hence it vanishes almost surely at innity.

18