The recent financial crisis caused dramatic widening and elevated volatilities among
basis spreads in cross currency as well as domestic interest rate markets. Furthermore,
the widespread use of cash collateral, especially in fixed income contracts, has made
the effective funding cost of financial institutions for the trades significantly different
from the Libor of the corresponding payment currency. Because of these market
developments, the text-book style application of a market model of interest rates has
now become inappropriate for financial firms; It cannot even reflect the exposures to
these basis spreads in pricing, to say nothing of proper delta and vega (or kappa)
hedges against their movements. This paper presents a new framework of the market
model to address all these issues.
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