Multi-Curve Framework for Swaps

Economic Background
Widening of basis spreads post 2007 crisis to consistently nonnegligible values. No evidence of spreads going back to pre crisis levels due to acceptance of segmentation of interest rate markets (including USD and EUR amongst others) into sub tenors with different credit and liquidity risks. Similar in nature to phenomenon of emergence of vol smiles after 87 crash.
Widening of basis spread because of liquidity and credit issues.

Existence of Arbitrage?
Consider two investment strategies: A: Receive semi-annual floating with underlying 6m Libor from a counterparty B: Pay quarterly floating with underlying 3M libor and then again at the end enter into similar agreement with another counterparty. In a single curve framework both strategy A and B almost nullify each other since under single curve framework:

Post crisis strategies A and B are valued differently due to liquidity preference for quarterly payments as well as credit quality of counterparties involved. So spread between A and B is not arbitrageable anymore.

Existence of Arbitrage?
Persistence of basis spreads in the market indicates there is considerable difference in credit and liquidity risk factors for different tenors or else the seemingly arbitrage opportunity would have nullified the spread. Hence the evolving market practice is now to construct separate curves for each underlying tenor {1M, 3M, 6M, 12M} or a yield surface for forward coupon projection

Libor rate as Risk Free Rate?

Issues of Discounting
Cash flows occurring at a future time must have a unique present value. Hence whatever be the projection curve framework, discounting curve must be unique. Arguments for OIS as the funding curve: OIS rates are linked to overnight rate controlled by the local central bank giving it more credibility than libor rate which is a polled rate. Further, recent libor rate fixing scandal also helps the case for OIS OIS rate is a weighted average rate of actually trading data whereas banks might not have traded at libor flat. For USD, GBP and Euro markets OIS quotes are available upto ~30 years, ,making them easier to be used for discount curve construction

Outline of Implementation
The systems across the world are shifting to multi curve framework. This necessitates having in place a generic framework to care of the situation. For example in some markets OIS quotes may not be deep enough for construction of a full discounting curve, a dealer can create his own curve with suitable choice of instruments. Here is an empirical model being practiced: One discounting curve (OIS/Customized Discounting curve) Multiple curves for forwarding. For example a pure 3M libor curve with maximum number of liquid instruments. Other curves for 1M, 6M, 12M to be created using market quotes of tenor basis spread with 3M curve/quoted liquid instruments.)

Hedging in Multi Curve Framework

Value of the swap in multi curve framework depends on both discounting curve as well as projection curve.

Where L is from forwarding curve and P is from discounting curve. Further for a swap dependence of its value at time any time t on discounting curve (P) is both direct as well as indirect since forwarding curve(L) itself has dependence on (P) making in total of 3 terms for delta hedging. OIS and S refer to funding and index respectively

Further Work
Exploring Libor Market Model in two curve framework for pricing of instruments based on dynamics of interest rate curves viz. caps floors and swaptions Using market data to validate and build upon above understanding so as to create scalable solutions by creating pilot projects using numerix.

References
Bianchetti 2009 Two curves one price Henrard Irony in Derivative discounting Fujii, Takahashi A note on construction of multiple swap curves with and without Collateral Google