Implications of Multiple Curve Construction in the Swedish Market

ERIK LIDHOLM BENJAMIN NUDEL

Master of Science Thesis Stockholm, Sweden 2014

Implikationer från Skapande av Multipla Kurvor på den Svenska Swapmarknaden

ERIK LIDHOLM BENJAMIN NUDEL

Examensarbete Stockholm, Sverige 2014 Implications of Multiple Curve Construction in the Swedish Swap Market

Erik Lidholm Benjamin Nudel

Master of Science Thesis INDEK 2014:46 KTH Industrial Engineering and Management Industrial Management SE-100 44 STOCKHOLM Implikationer fr˚an Skapande av Multipla Kurvor p˚a den Svenska Swapmarknaden

Erik Lidholm Benjamin Nudel

Examensarbete INDEK 2014:46 KTH Industriell teknik och management Industriell ekonomi och organisation SE-100 44 STOCKHOLM Master of Science Thesis INDEK 2014:46

Implications of Multiple Curve Construction in the Swedish Swap Market

Erik Lidholm Benjamin Nudel

Approved Examiner Supervisor 2014-06-04 Hans L¨o¨of Tomas S¨orensson

Commissioner Contact Person - -

Abstract

The global financial crisis of 2007 caused abrupt changes in the financial markets. Interest rates that were known to follow each other diverged. Furthermore, both regulation and an increased awareness of counterparty credit risks have fuelled a growth of collateralised contracts. As a consequence, pre-crisis swap pricing methods are no longer valid. In light of this, the purpose of this thesis is to apply a framework to the Swedish swap market that is able to consistently price interest rate and cross swaps in the presence of non-negligible cross currency basis spreads, and to investigate the pricing differences arising from the use and type of collat- eral. Through the implementation of a framework proposed by Fujii, Shimada and Takahashi (2010b), it is shown that the usage of collateral has a noticeable impact on the pricing. Ten year forward starting swaps are found to be priced at lower rates under collateral. Moreover, the results from pricing off-market swaps show that disregarding the impact of collateral would cause one to consistently underestimate the change in value of a contract, whether in or out of the money. The choice of collateral currency is also shown to matter, as pricing under SEK and USD as the collateral yielded different results, in terms of constructed curves as well as in the pricing of spot starting, forward starting and off-market swaps. Based on the results from the pricing of off-market swaps, two scenarios are outlined that exemplify the importance of correct pricing methods when terminating and novating swaps. It is concluded that a market participant who fails to recognise the pricing implications from the usage and type of collateral could incur substantial losses.

Keywords: collateral, cross currency, discount curve, forward curve, forward starting, off- market, swap, Stibor

i Examensarbete INDEK 2014:46

Implikationer fr˚anSkapande av Multipla Kurvor p˚aden Svenska Swapmarknaden

Erik Lidholm Benjamin Nudel

Godk¨ant Examinator Handledare 2014-06-04 Hans L¨o¨of Tomas S¨orensson

Uppdragsgivare Kontaktperson - -

Sammanfattning

Finanskrisens utbrott ˚ar2007 orsakade abrupta f¨or¨andringari finansmarknaden. R¨antor som tidigare f¨oljtvarandra divergerade. Vidare gav b˚adereglering av finansmarknaden och en ¨okad medvetenhet om motparters kreditrisk upphov till en tillv¨axtav kontrakt med st¨alldas¨akerheter. F¨oljaktligen¨ardet inte l¨angrekorrekt att priss¨attaswappar enligt metoder fr˚antiden f¨orefi- nanskrisen. Mot bakgrund av detta ¨arsyftet med denna uppsats att applicera ett ramverk p˚a den svenska swapmarknaden som p˚aett konsekvent s¨attkan priss¨attar¨ante- och valutaswap- par med icke negligerbara r¨antespreadar, samt att unders¨oka prisskillnaderna som uppst˚arfr˚an anv¨and