Applied Modeling Techniques and Data Analysis 2

6An Arbitrage-free Large Market Model for Forward Spread Curves

Before the financial crisis started in 2007, the forward rate agreement contracts could be perfectly replicated by overnight indexed swap zero coupon bonds. After the crisis, the simply compounded, risk-free, overnight indexed swap forward rate became less than the forward rate agreement. Using an approach proposed by Cuchiero, Klein and Teichmann, we construct an arbitrage-free market model, where the forward spread curves for a given finite tenor structure are described as a mild solution to a boundary value problem for a system of infinite-dimensional stochastic differential equations. The constructed financial market is large: it contains infinitely many overnight indexed swap zero coupon bonds and forward rate agreement contracts, with all possible maturities. We also investigate the necessary assumptions and conditions which guarantee existence, uniqueness and non-negativity of solutions to the obtained boundary value problem.

6.1. Introduction and background

In the last decades of the previous century and for the duration of the third millennium, financial derivatives have significantly affected finance and the global market. In terms of underlying assets, the derivative market is massive, meaning that it is much larger than the stock market and, in terms of value, it is several times the world gross domestic product. In addition, derivative markets have been considered as the core of the financial crisis ...