Rethinking Valuation and Pricing Models

9

The Widening of the BasisNew Market Formulas for Swaps, Caps and Swaptions

Fabio Mercurio

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Chapter Outline

9.1 Introduction

9.2 Assumptions on the Discount Curve

9.3 Fra Rates: Definition and Pricing

9.4 IRS Valuation

9.5 Pricing of Caplets and Swaptions

9.5.1 Market formula for caplets and floorlets

9.5.2 Market formula for swaptions

9.6 Conclusions

References

9.1 Introduction

The 2007 liquidity crisis widened the Libor–overnight indexed swap (OIS) basis. Market rates that used to be consistent with each other suddenly diverged. For instance, the forward rates implied by two consecutive deposits became different than the corresponding quoted forward rate agreement (FRA) rates or forward rates ...