Choosing the Right Spread

Abstract

In this paper we analyse the modelling of deterministic funding and tenor basis spreads for the pricing of Libor exotics. In particular tenor basis may be modelled by means of simple compounded or continuous compounded forward rate spreads. We compare resulting payoff adjustments and discuss implications on pricing model implementations. Moreover, we analyse a simplified payoff adjustment and gauge the valuation inaccuracy resulting from inconsistencies in its definition.

Keywords: interest rate model, multi-curve modelling, tenor and funding basis spread, Libor, OIS, cross-currency

JEL Classification: E43, G12, G13