I recently stumbled upon an interesting book about post-crisis interest-rate modelling. Besides future changes in the LIBOR and possible EURIBOR fixing after the manipulations of the past few years, counter-party default and collateral become important.
Changes in Interest-Rate and Credit Instrument Pricing
Pre-crisis, there was a risk-free rate on which the market agreed. This way, different banks could create interest-rate swap transactions using basically the same conditions with different counter parties. This also meant that one could price the different instruments with the same discount curve.
Now, this risk-free rate has disappeared. The market has created a new view on credit risk. This view requires that collateral is set aside for transactions which were seen as risk-free before the crisis. A more detailed credit default modelling is also required – which is non-trivial. It seems that there is no established market standard for pricing the instruments consistently, yet. Chris Kenyon and Roland Stamm propose such a framework in their new book:
The presented framework is quite complex. It involves several additional parameter curves. For me, the effort seems to be too much for most cases. But, it is a great starting point for a new pricing framework to evolve.
A presentation with some of the insights is available at PRMIA: Presentation: Discounting and Curve Construction Since the Beginning of Financial Crisis 2007
It is interesting to see that pre-crisis, the pricing challenge lay in the complexity of the products. Post-Crisis, the challenge is already pricing simple products.
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