Consistent Valuation across Curves Using Pricing Kernels

• Main Authors: Andrea Macrina, Obeid Mahomed
• Format: Article
• Language: English
• Published: MDPI AG 2018-03-01
• Series: Risks
• Subjects: pricing kernel approach; rational pricing models; multi-curve term structures; OIS and LIBOR; spread models; HJM; multi-curve potential model; linear-rational term structure models; inflation-linked and foreign-exchanged securities; valuation in emerging markets
• Online Access: http://www.mdpi.com/2227-9091/6/1/18

The general problem of asset pricing when the discount rate differs from the rate at which an asset’s cash flows accrue is considered. A pricing kernel framework is used to model an economy that is segmented into distinct markets, each identified by a yield curve having its own market, credit and liquidity risk characteristics. The proposed framework precludes arbitrage within each market, while the definition of a curve-conversion factor process links all markets in a consistent arbitrage-free manner. A pricing formula is then derived, referred to as the across-curve pricing formula, which enables consistent valuation and hedging of financial instruments across curves (and markets). As a natural application, a consistent multi-curve framework is formulated for emerging and developed inter-bank swap markets, which highlights an important dual feature of the curve-conversion factor process. Given this multi-curve framework, existing multi-curve approaches based on HJM and rational pricing kernel models are recovered, reviewed and generalised and single-curve models extended. In another application, inflation-linked, currency-based and fixed-income hybrid securities are shown to be consistently valued using the across-curve valuation method.