Post-shock short-rate pricing

The basis between swaps referencing funded fixings and swaps referencing overnight collateralised fixings has increased in importance with the 2007–09 liquidity and credit crises. This basis means that new pricing models for fixed-income staples such as caps, floors and swaptions are required. Recently, new formulas have been proposed using market models. Here, Chris Kenyon presents equivalent pricing in a short-rate framework, which is important for applications involving credit, such as credit value adjustment, because default can occur at any time

The 2007–09 liquidity and credit crises included large basis spreads opening up between overnight collateralised instruments (for example, six-month Eonia) and non-collateralised fixings1 (for example, six-month Euribor). Deposits of the same maturity as fixings follow the same pattern. Yield curves built from instruments referencing these different rates demonstrate a significant basis (for example, building from Eonia swaps versus building from Euribor swaps). This means that new formulas are