Seminar in applied mathematics and statistics

SPEAKER: Raquel Gaspar (Lisbon)

TITLE: Interbank Convexity Adjustments

ABSTRACT:
Convexity adjustments are used by practitioners to value non standard products using information on plain vanilla products. The real world interbank market is not populated risk less banks. This became particularly obvious after the financial crisis of 2007-2009. Nonetheless, most theoretical interest rate models, assume the risk in the interbank lending market is negligible, using interest rate sensitive products to build zero-coupon bonds curves. Here we take a different approach and consider the Libor rate L(t,T) is no longer a good approximation to the truly default-free interest rate. Thus, the value of contracts having as underlying the Libor rate, should be adjusted to correct for the true risk existent in the Libor rate. We call that adjustment an interbank convexity adjustment. In this paper we explicitly compute the interbank convexity adjustment of FRAs (Forward Rate Agreements), combining the classical affine term structure (ATS) framework with shot-noise process that are able to capture the counter-party risk of interbank contracts. (Joint work with José Cruz.)

Tea and chocolate will be served in room 04.3.15 after the seminar.