Consistent Valuation Across Curves Using Pricing Kernels

Andrea Macrina; Obeid Mahomed

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arXiv · 1801.04994

Consistent Valuation Across Curves Using Pricing Kernels

Andrea Macrina·Obeid Mahomed

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Abstract

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.

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Andrea Macrina, Obeid Mahomed. 2018-01-15. Consistent Valuation Across Curves Using Pricing Kernels. https://arxiv.org/abs/1801.04994

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