Consistent Valuation Across Curves

Using Pricing Kernels

Andrea Macrina† ‡∗, Obeid Mahomed§

†
Department of Mathematics, University College London
London WC1E 6BT, United Kingdom

‡
Department of Actuarial Science, University of Cape Town
Rondebosch 7701, South Africa

§
African Institute of Financial Markets and Risk Management
University of Cape Town, Rondebosch 7701, South Africa

February 16, 2018

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.

Keywords: Pricing kernel approach; rational pricing models; multi-curve term struc-
tures; 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.
∗
Corresponding author: a.macrina@ucl.ac.uk

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1 Introduction

The fundamental problem that we consider is the valuation of a financial instrument us-
ing a discounting rate which differs from the rate at which the instrument’s future cash
flows accrue. Since such financial instruments are synonymous with fixed income assets,
we will focus thereon. Nonetheless, we have no reason to believe that the framework that
we develop cannot be extended to the valuation of a generic financial asset. The financial
crisis brought this valuation problem to the foreground when substantial spreads emerged
between inter-bank interest rates that were previously bound by single yield curve consis-
tencies, culminating in a new valuation paradigm of multiple yield curves—one used for
discounting (the overnight indexed swap (OIS) yield curve) and others used for forecasting
of cash flows (the y-month inter-bank offered rate (IBOR) curve, y = 1, 3, 6, 12). However,
this problem was also prevalent pre-crisis when an economy is considered, which has an
inter-bank swap market, a government bond market and trades in the global economy via
the foreign exchange market, resulting in three different curves: the nominal swap curve,
the government bond curve and the foreign exchange basis curve. The valuation of any
financial instrument that is issued in one of these markets, but has cash flows that are de-
termined by any of the other markets, once again manifests the fundamental problem.
In this paper, we directly address the fundamental problem, articulated above, in a gen-
eral sense. Considering the aftermath of the financial crisis however, academic literature on
multi-curve interest rate modelling (in the context of the developed inter-bank swap mar-
ket) has evolved rapidly. Here we classify this literature into four categories or modelling
approaches and provide a non-exhaustive list of references and a brief summary of the main
contributions therein.
The first category is short-rate models. Kijima et al. [33] propose a three-yield curve
model (discount, swap and government bond curve) for an economy with the respective
short-rates governed by Gaussian, exponentially quadratic models. Kenyon [32] and Morini
& Runggaldier [42] consider Vasicek, Hull-White (HW) and Cox-Ingersoll-Ross (CIR) short-
rate models for the OIS, IBOR and/or OIS-IBOR spread curves. Filipović & Trolle [16]
propose a Vasicek process with stochastic long-term mean as the OIS short-rate model with
explicit models for default and liquidity risk. Alfeus et al. [3] adopt a novel approach
of modelling “roll-over risk” explicitly in a reduced-form setting and consider multi-factor

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CIR-type processes for this and the OIS short-rate.
Heath-Jarrow-Morton (HJM) models constitute the second category. Pallavicini & Tarenghi
[45], Fujii et al. [21], Moreni & Pallavicini [41], Crépey et al. [10] and Miglietta [39] all
focus on a hybrid HJM-LMM (LIBOR Market Model) approach where the OIS curve is mod-
elled using the classical HJM model, while the IBOR forward rates are modelled in an ad
hoc manner. Crépey et al. [9] pioneered the use of the HJM framework via a credit risk
analogy, while Miglietta [39] and Grbac & Runggaldier [23] do the same using a foreign
exchange (FX) analogy. Pallavicini and Tarenghi [45] focus on aspects of calibration, while
Moreni & Pallavicini [41] propose a specific Markovian factor representation which expe-
dites calibration. Crépey et al. [10] consider Lévy driven models, while Cuchiero et al. [12]
consider a general semimartingale setup with multiplicative OIS-IBOR spreads.
Category three is the class of LIBOR Market Models (LMMs). Morini [40], Mercurio [35],
[36], [37], [38] and Bianchetti [5] were the first to extend the LMM to a multi-curve setting,
with the latter doing so via an FX analogy. Mercurio [36] and Mercurio and Xie [43] for-
malised the first approach utilising an additive spread between OIS and IBOR forward rates
that were modelled as martingales under the classical forward measure, while Ametrano
and Bianchetti [4] formalised the associated multi-curve bootstrapping process. Grbac et
al. [22] provide an alternative to the aforementioned approach using a class of affine LIBOR
models, first proposed by Keller-Ressel et al. [31].
The fourth and final catergory are pricing kernel models. At the present time, we are only
aware of Crépey et al. [11] and Nguyen & Seifried [44] who have formulated multi-curve
systems with pricing kernels. We highlight here that, in our opinion, both these papers
adopt a hybrid pricing kernel-LMM approach since the OIS curve is modelled with a pricing
kernel while the IBOR process is modelled in an ad hoc fashion—we will expand on this in
Sections 3 and 5. In this paper we develop a pure pricing-kernel based approach, which we
believe to be the first of such a modelling class.
For a detailed review of the post-crisis multi-curve interest rate paradigm from both, a
theoretical and practical perspective, we refer the reader to Bianchetti & Morini [6], Grbac
& Runggaldier [23] and Henrard [24].
The solution that we propose rests upon a pricing formula, which we call the across-
curve pricing formula. This formula has a pricing kernel-based model for the economy as its
foundation. More specifically, the pricing kernel framework models the set of yield curves
associated with the respective economy under consideration. This enables us to link the
set of yield curves in a consistent arbitrage-free manner through the definition of a curve-
conversion factor process. This conversion process plays an important dual role, giving rise

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to the across-curve pricing formula that enables consistent valuation and hedging of financial
instruments across curves. It turns out that the curve-conversion factor process is consistent
with an FX process in multi-currency modelling in a pricing kernel framework, and there-
fore our approach is also consistent with the FX analogy first proposed by Bianchetti [5] for
interest rate derivatives (or the developed inter-bank swap market) in an LMM setting. In
our work we are interested in more than developed markets or the inter-bank swap market,
and endeavour to build consistent relations among a wide variety of developed and emerging
market fixed-income assets including inflation-linked notes, FX contracts, and hybrid prod-
ucts such as inflation-linked FX instruments. Here, we mention Flesaker & Hughston [18]
and [19] for an argitrage-free pricing kernel approach to the valuation of FX securities, and
to Frey & Sommer [20] if one were to consider extending classical short rate models, based
on diffusion processes with deterministic coefficients, for FX-rates. The approach by Jarrow
& Yildirim [29], based on the HJM-framework, might be treated as in Section 4 and used
for inflation-linked pricing as shown in Section 6, later in this paper. We note here the early
work in 1998 by Hughston [25] who produced a general arbitrage-free approach to the pric-
ing of inflation derivatives, in which—to our knowledge—a foreign exchange analogy was
used in such a context, for the first time. In Hughston’s work, the CPI is treated like a foreign
exchange rate that links the nominal and the real price systems as if they were domestic and
foreign currencies, respectively. The work by Pilz & Schlögl [46] on modelling commodity
prices re-interprets a multi-currency LMM approach. Similarities can be seen when applying
our approach to multi-currency and multi-curve LIBOR models, as developed in Section 6.3,
where an FX-LIBOR forward rate agreement is priced. In all that follows, we refer to the
discounting curve as the x-curve and the forecasting curve as the y-curve. Therefore, when
describing our framework, we speak of the xy-formalism, while we refer to the application
thereof as the xy-approach.
With regard to the multi-curve system adopted by developed market practitioners for their
inter-bank swap market, we will show that there is a natural formulation of such a system
within our framework. Moreover, we will show that this natural formalism is not adopted by
practitioners, or the market in a strict sense in general. Rather, practitioners have adopted a
more rigid version of the flexible multi-curve system we propose, the choice of which results
and ensures simpler specifications for fundamental interest rate products, i.e. forward rate
agreements (FRAs) and interest rate swaps (IRSs). We also formulate a multi-curve system
for emerging markets, one that is remarkably consistent with the corresponding developed
market system—this feature being entirely attributable to the critical dual role played by
the curve-conversion factor process. We will expand on this in Sections 2 and 3.

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 The remainder of this paper is structured as follows: Section 2 introduces the curve-
conversion factor process and the across-curve pricing formula. Section 3 introduces consis-
tent multi-curve interest rate systems for developed and emerging inter-bank swap markets.
Section 4 reviews and reformulates existing HJM multi-curve modelling approaches within
the context of the xy-approach, and introduces a new framework that we call the xy-HJM
framework. Section 5 introduces a generic class of rational multi-curve models and revisits
recent rational multi-curve approaches based on pricing kernels in light of the xy-framework.
Moreover, the linear-rational term structure models are shown to belong to a more general
class of pricing-kernel-based (rational) models and are extended to the multi-curve setup.
In Section 6, the across-curve pricing approach is adopted to price inflation-linked and FX
securities, including hybrid contracts. In Section 7 we draw various conclusions and take
the opportunity to summarise our findings.

2 Across-curve pricing formula

In this section we define the curve-conversion factor process and deduce what we term the
across-curve pricing formula. At the basis of the curve-conversion factor process lies the
assumption that, within a given economy, there is a distinct market associated with each
curve. Each of these markets are characterised by its own set of market, liquidity and credit
risk factors. In turn, each set of market, liquidity and credit risk factors may be systematic or
idiosyncratic in nature. The curve-conversion factor process plays a dual role: (i) it provides
a mechanism—akin to a ladder—that enables one to transit consistently from one discount
curve system to another; and (ii) it facilitates the equivalent representation of cash flows
across markets (or curves), no matter what financial instrument is implicitly being priced
or interest rate system being modelled. This feature enables consistent valuation across
different curves (or markets). The paradigm we shall adopt for the development of the
across-curve pricing approach is one based on pricing kernels. Previous works developing
and applying the pricing kernel paradigm comprise, e.g., Constantinides [8], Flesaker &
Hughston [17] and [19], Rogers [47], Jin & Glasserman [30], Hughston & Rafailidis [26],
Akahori et al. [1], Macrina [34], and Filipović et al. [15]. Next, we introduce the stochastic
basis and the pricing kernel system.
We consider a filtered probability space (Ω, F , (F t ) t≥0 , P), where (F t ) t≥0 denotes the
filtration and P the real-world probability measure. We introduce an (F t )-adapted pricing
kernel process (h t ) t≥0 , which governs the inter-temporal relation between asset values at
different times in a financial market. It is a fundamental ingredient in the so-called standard

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no-arbitrage pricing formula, for a non-dividend-paying financial asset H, given by

1
Ht = E [h T H T | F t ] . (2.1)
ht

The no-arbitrage asset price process (H t ) t≥0 is obtained by taking the conditional expec-
tation of the random cash flow H T , occurring at the fixed future date T ≥ t ≥ 0, that is
discounted by the pricing kernel. Standard references, in which asset pricing using pricing
kernels is discussed, include, e.g., Hunt & Kennedy [27], Duffie [14], Cochrane [7], and
Grbac & Runggaldier [23].
In order for us to deduce the across-curve pricing formula—seen as an extension to the
pricing formula (2.1)—we assume the existence of a set of (continuous-time) (F t )-adapted
y
pricing kernel processes (h t ) t≥0 , where y = 0, 1, 2, . . . , n, each linked to a distinct y-market.
y
The price H t at t ∈ [0, T ] of a non-dividend-paying financial asset H, with (random) cash
y
flow H T at the fixed future date T , is then given by

y 1  y y 
Ht = y E hT H T | Ft . (2.2)
ht

The superscript y emphasises that the pricing formula (2.2) holds for the valuation of assets
y
in the y-economy (or in the y-market). In fact, the pricing kernel process (h t ) governs the
inter-temporal relation between the present value of financial assets and their future cash
flows in the associated y-economy. It then follows in a straightforward manner, that the
y y y
price process (Pt T )0≤t≤T of a zero coupon bond (ZCB), with payoff H T = PT T = 1 at the
fixed maturity T and quoted in the y-market, is given by

y 1  y 
Pt T = y E hT | Ft .
ht

The discount bond system—spanned in theory by a continuum, but in practice a finite num-
ber of maturities T = T1 , T2 , . . . , Tn —generates a term structure curve. Since this curve is
indexed by the particular market y, we refer to it as the y-curve. In all that follows, we sin-
gle out one of the set of the y-markets (and thereby its associated y-curve) and refer to it
as the x-market (and its associated term structure curve as the x-curve); of course then this
market also has an associated (F t )-adapted pricing kernel (h tx ). The x-market is the mar-
ket within which pricing (or discounting) occurs, while the y-market will denote the market
within which the cash flows of the financial instruments are forecasted (or accrued).
The fundamental pricing problem that is considered in this paper is one where a financial

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instrument accrues cash flows at a rate of interest that differs from that used for discounting.
First we consider the problem of cash flow forecasting and equivalent representation under
different curves (or markets), before we tackle the problem of valuation (or discounting).
An equivalent cash flow representation across curves (or markets) is justified in Appendix A
using no-arbitrage portfolio-based strategies. These findings are formalised in the following
definition that introduces the curve-conversion factor process.

Definition 2.1. Consider an economy with n distinct markets characterised by a set of pricing
y y
kernel processes (h t ) and associated discount bond systems (Pt T ), where y = 0, 1, 2, . . . , n and
y
0 ≤ t ≤ T . The converted value C tx in the x-market at time t of any spot cash flow C t
determined in the y-market is given by
y
ht y
C tx = Ct ,
h tx

where x, y = 0, 1, . . . , n. The converted value C tx (t, T ) at time t in the x-market of any forward
y
cash flow C t (t,T), measurable at time t but payable at time T , determined in the y-market is
given by
y y
h t Pt T y
C tx (t, T ) = C t (t, T ) ,
h tx PtxT
where x, y = 0, 1, . . . , n. These two relations are combined by the definition of the (F t )-adapted
curve-conversion factor process
 y  y y
xy E hT | Ft h t Pt T
QtT =  x = x x , (2.3)
E hT | Ft h t Pt T

where t ∈ [0, T ] is the time until which the cash flow being converted is measurable and T > 0
is the payment date.
y
We note that the cash flows C tx (t, T ) and C t (t, T ) are linked by the identity C tx (t, T ) =
xy y
Q t T C t (t, T ), for t ∈ [0, T ]. With this definition at hand, we now have the necessary tool
to resolve the fundamental pricing problem considered in this paper, i.e. valuing a generic
financial instrument that accrues cash flows under one curve, the y-curve, but is priced
under another curve, the x-curve. Our approach is consistent with the FX analogy proposed
by Bianchetti [5], but formalised in an economy modelled by a set of pricing kernels—we
describe our approach as the xy-formalism. At the heart of this formalism is the pricing
formula presented next. We refer to this formula as the across-curve pricing formula. The
relation of this novel formula to the fundamental pricing formula (2.1) is shown in the proof

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of the following proposition.

Proposition 2.1. Let 0 ≤ s ≤ t ≤ T . Consider a generic financial asset H that has a single F t -
y
measurable cash flow H t (t, T ) occurring at the fixed time T ≥ t and determined by the y-curve
y
(or the y-market). It is noted that in the time interval [t, T ], the quantity H t (t, T ) is fixed at
xy
the value observed at time t ≥ 0. Within the x y-approach, the price process (HsT )0≤s≤T of a
financial instrument, determined by the x-curve (or x-market) and contingent on the asset H,
is given by
1  x x xy y
 

x
E h t Pt T Q t T H t (t, T ) | Fs , 0 ≤ s < t,
 hs


xy
HsT = (2.4)


 P x Q x y H y (t, T ),

t ≤ s ≤ T.
sT t T t

xy
The curve-conversion factor process (Q t T )0≤t≤T is introduced in Definition 2.1.

Proof. For information we note that, by an application of the relation (2.2), the price process
y
(H t )0≤t≤T of the financial asset H is deduced to be

y 1  y y  y y
Ht = y E h T H t (t, T ) | F t = H t (t, T )Pt T , (2.5)
ht

y
since the cash flow H t (t, T ) is F t -measurable and it occurs at T . At time t ∈ [0, T ], we con-
y
vert H t (t, T ) to the corresponding value H tx (t, T ) in the x-market by use of the conversion
xy
factor Q t T :
xy y
H tx (t, T ) = Q t T H t (t, T ). (2.6)

Now we insert the converted cash flow H tx (t, T ) in the standard no-arbitrage formula (2.1)
(or formula (2.2), where y=0 is taken to be the x-curve) where h t = h tx is assumed. We
have,
x 1  x x 
HsT = x
E h t H t (t, T ) | Fs . (2.7)
hs
Given that H tx (t, T ) is F t -measurable, we deduce the following by the tower property of
conditional expectation:

x 1   x   1  
HsT = x
E E h T | F t H tx (t, T ) | Fs = x E h tx PtxT H tx (t, T ) | Fs , (2.8)
hs hs

for 0 ≤ s < t. In addition, for t ≤ s ≤ T , we have HsT

x
= PsT
x
H tx (t, T ). Recalling that
xy y xy
H tx (t, T ) = Q t T H t (t, T ), and by choosing to write HsT for HsT
x
in order to emphasise the
interaction between the x- and the y-curves, the proof is complete. We add that the one-

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to-one across-curve extension to the standard pricing formula (2.1) is recovered by setting
t = T in the relation (2.4).
y
Remark 1. When t = T and H T T = 1, using Proposition 2.1, we may define the ZCB

xy 1  y  xy y xy
PsT = x
E h T | Fs = Q ss x
PsT = PsT Q sT , (2.9)
hs

for s ∈ [0, T ], which has two representations using the definition of the conversion factor (2.3).

Given Proposition 2.1, we can now present the dual role played by the curve-conversion
factor process, within the xy-formalism, which is described in the following corollary.
y
Corollary 2.1. Within the xy-formalism, if the cash flow H t (t, T ) is directly observable in the
economy, then the curve-conversion factor process enables valuation by acting at the level of the
discounting curve as follows:

xy 1  x x xy y  1  y y y 
HsT = E h P Q
t tT tT H t (t, T ) | F s = E h t PtT H t (t, T ) | Fs . (2.10)
hsx hsx

xy
However, if the curve-converted cash flow H t T is directly observable in the economy, then the
curve-conversion factor process enables valuation by acting at the level of the cash flow as
follows:
xy 1  x x xy y  1  x xy 
HsT = E h t Pt T Q t T H t (t, T ) | F s = E h t H t T | Fs , (2.11)
hsx hsx
xy y
where (HsT )0≤s≤t is the x-market value of H t (t, T ), for s ≤ t ≤ T .
y
Proof. If H t (t, T ) is determined in the y-market and directly observable (i.e. quoted) within
the economy, then according to Proposition 2.1 the value of such a payoff within the x-
market, at the future terminal time T , is given by

xy xy y
H T T = Q t T H t (t, T ), (2.12)

xy
which is model-implied, since the curve-conversion factor process Q t T is determined by
y xy
the specific forms of the pricing kernels (h tx ) and (h t ), respectively. Therefore, since H T T
xy
is not directly observable in the economy due to Q t T , the curve-conversion factor process
is subsumed into the discounting process in Eq. (2.4) for 0 ≤ s < t, by observing that
xy y y
h tx PtxT Q t T = h t Pt T , which yields Eq. (2.10).
y xy
Conversely, if H t (t, T ) is determined in the y-market but the converted quantity H T T is

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directly observable within the economy, then
xy
y HT T
H t (t, T ) = xy , (2.13)
QtT

xy
is model-implied, which is subsumed into the cash flow process by observing that HsT =
xy y
x
PsT Q t T H t (t, T ) for t ≤ s ≤ T from Eq. (2.4), which yields Eq. (2.11).

Remark 2. Corollary 2.1 proves to be critical in Section 3, where consistent mutli-curve sys-
tems are derived for both, developed and emerging inter-bank swap markets. With regard to
FRAs (the fundamental inter-bank swap market derivative), which has an IBOR process as its
underlying, it turns out that the y-market determined IBOR process is directly observable in
the emerging market, but its curve-converted equivalent is directly observable in the developed
market. In this instance, the dual nature of the curve-conversion factor process caters for this
apparent cross-economy market inconsistency, resulting in one consistent modelling framework.

In Appendix B, we provide the consistent set of changes of numeraire assets and associ-
ated equivalent probability measures, which ensure that no arbitrage is produced when the
across-pricing formula is applied using an equivalent martingale measure.

3 Pricing kernel approach to multi-curve systems

First we consider the definition of a spot IBOR, i.e. a deposit rate that is offered at a fixed
time t ≥ 0 by a set of suitably credit-rated banks within a given economy. We assume that
the maturity of said IBOR is t + δ > t, so that the associated tenor is given by δ > 0. Then
we may define (or represent) the spot IBOR process via ZCB instruments by

1 1
 ‹
L t (t, t + δ) = −1 , (3.1)
δ Pt t+δ

where t ≥ 0, δ > 0, and where Pt t+δ is the price at time t of a ZCB, with tenor δ, that
matures at time t + δ. In the classical single-curve framework, where IBORs are consid-
ered an appropriate proxy for risk-free rates and where a tradable discount bond system
is assumed, one can then proceed to define the forward IBOR process via the canonical
no-arbitrage pricing relation

1  
L t (Ti−1 , Ti ) = E h Ti−1 PTi−1 Ti L Ti−1 (Ti−1 , Ti ) F t , (3.2)
h t Pt Ti

10

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for 0 ≤ t ≤ Ti−1 , and where δi = Ti − Ti−1 is the IBOR tenor and (h t ) t≥0 is the pricing kernel
process. By use of the relation (3.1) with t = Ti−1 and δ = δi , and the ZCB pricing relation
h t Pt Ti = E[h Ti−1 PTi−1 Ti | F t ], one obtains the forward IBOR process
 
1 Pt Ti−1
L t (Ti−1 , Ti ) = −1 , (3.3)
δi Pt Ti

for 0 ≤ t ≤ Ti−1 . We note that the product of the pricing kernel process and the discounted
forward IBOR process (h t Pt Ti L t (Ti−1 , Ti ))0≤t≤Ti−1 is an ((F t ), P)-martingale, which is anal-
ogous to the forward IBOR process being a martingale under the Q Ti -forward measure in
the classical single-curve theory.
The classical relation (3.3) states that the forward IBOR value at time t can be replicated
by a linear combination of zero-coupon bonds, i.e. by one maturing at the IBOR reset date
Ti−1 and another ZCB maturing at the IBOR settlement date Ti . In a market where the
spread between an overnight indexed swap (OIS) rate and the corresponding IBOR is non-
zero, relation (3.3) is no longer acceptable. That is, the now risky IBOR can no longer be
replicated using risk-free ZCBs. In oder words, the IBOR market is exposed to risk factors
which are not necessarily affecting the risk-free ZCB market, while the risk exposure also
varies depending on the IBOR tenor δi = Ti − Ti−1 one is investing in. Hence, one needs
to assume that holding a financial contract written on a 3-month IBOR exposes an investor
to a different risk profile than when holding an instrument written on a 6-month IBOR.
It follows that assuming risk-free ZCBs can replicate the same risk exposures as contracts
written on an IBOR is wrong because: (a) an IBOR may be subject to more risk sources
than the risk-free ZCBs; and (b) the number of risk factors affecting an IBOR contract may
depend on the IBOR tenor.
We ask the following question: If one insisted on keeping the relation (3.3), albeit subject
to modifications, how would one need to adjust—in a consistent and arbitrage-free manner—
the relation between an IBOR model and the associated ZCBs in a multi-curve setup? It turns
out that the answer is an extension based on the xy-formalism introduced above. Here is
how we do it.
First, we consider a collection of interest rate curves indexed by x, y = 0, 1, 2, ..., n where
we refer to the x-curve as the discounting curve and the y-curve as the forecasting curve. An
example for a pair of curves (x, y) may be the pair (0, 1) where the 0-curve is the OIS
curve and the 1-curve is the 1-month IBOR curve. The case where x = y is the (classical)

11

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single-curve economy. Next we make the relationship (3.3) curve-dependent and write
‚ y Œ
y 1 Pt T
L t (Ti−1 , Ti ) =
i−1
y −1 . (3.4)
δi Pt T
i

y
Thus, the y-ZCB system Pt T has an associated y-tenored IBOR, which is subject to the
i

same set of risk factors, i.e. the y-tenored IBOR defines the y-ZCB system. Moreover, the
y y y
y-ZCB price process satisfies the martingale relation h t Pt T = E[h T | F t ], which is to say
i i

that no-arbitrage is assumed within the self-consistent y-market.

Next we detail the development of consistent multi-curve interest rate systems inspired
by the xy-formalism for both, emerging and developed markets.

3.1 Discounting systems in emerging markets

In this section we consider the simpler case of an emerging market, in particular one where
no OIS zero-coupon yield curve exists. To be precise, the spot overnight rate is observable
but there are no tradable and liquid overnight indexed swaps, i.e. there is no OIS derivative
market to enable the construction of a yield curve. For more information on the specific
nuances and issues relating to emerging inter-bank swap markets, we refer the reader to
Jakarasi et al. [28], and references therein, who consider the problem of estimating an OIS
zero-coupon yield curve in South Africa. In such a market, all forecasting and discounting
of cash flows is done by one liquid, risky y-tenored IBOR zero-coupon yield curve, only.
To derive the multi-curve discounting system within the xy-formalism, we first consider
the pricing of standard FRAs. FRAs are the fundamental primitive securities in any interest
rate market, which facilitate price discovery for forward IBORs. The FRA considered here
has reset time Ti−1 > 0 and maturity time Ti > Ti−1 , which is also assumed to be the
y
settlement time, and is therefore written on the future spot IBOR L T (Ti−1 , Ti ). The value
i−1
yy
at time t ∈ [0, Ti ] of this FRA is denoted by Vt T , with the first character of the superscript
i

indicating the discount curve, and the second character denoting the forecasting curve. For
a unit nominal, the FRA’s payoff at Ti is given by
€ Š
yy y
VT T = δi L T (Ti−1 , Ti ) − K y , (3.5)
i i i−1

where K y is an arbitrary strike rate expressed in the y-market. We emphasise that the FRA’s
payoff is actually measurable at time Ti−1 , however the actual cash flow is only paid at time

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 yy
Ti .1 As a consequence, we may also define the in-advance FRA payoff VT at Ti−1 , which
i−1 Ti
yy y
is the value VT T discounted by PT T , by
i i i−1 i

€ Š
yy y y
VT = PT δ
T i L (T ,
i−1 iT ) − K y
. (3.6)
i−1 Ti i−1 i T i−1

Using the pricing formula (2.4) with x = y, along with relations (3.2), (3.3) and (3.4), the
FRA price process is derived as

yy δi ”
y yy
— δi ”
y y
€
y
Š —
Vt T = y E hT VT Ft = y E hT PT L T (Ti−1 , Ti ) − K y Ft
i−1 Ti i−1 Ti
i
ht i−1
ht i−1 i−1

y y

= δi Pt T L t (Ti−1 , Ti ) − K y
i
y y
= Pt T − (1 + δi K y )Pt T . (3.7)
i−1 i

yy
By setting Vt T = 0, the fair FRA rate process is recovered and is given by
i

yy y
K t (Ti−1 , Ti ) = L t (Ti−1 , Ti ), (3.8)

yy
for t ∈ [0, Ti−1 ]. The notation K t (Ti−1 , Ti ) emphasises that this fair FRA strike rate applies
when the y-curve is used for both, discounting and forecasting.
Next we consider a standard IRS with unit nominal, reset times {T0 , T1 , . . . , Tn−1 }, pay-
ment times {T1 , T2 , . . . , Tn }, referencing the y-tenored IBOR and arbitrary fixed swap rate
under the y-market denoted by S y . Again applying pricing relation (2.4) with x = y, to-
gether with relations (3.2), (3.3) and (3.4), the IRS price process is derived as

n
yy
X δi ” €
y y
Š —
Vt T = y E h T L T (Ti−1 , Ti ) − S y F t
n
h
i=1 t
i i−1

n
X
y y y
= Pt T − Pt T − S y δi Pt T , (3.9)
0 n i
i=1

for t ≤ T0 . Using the same notation convention as with the FRA, the fair IRS rate process is
given by
y y
yy
Pt T − Pt T
S t (T0 , Tn ) = Pn
0 n
y , (3.10)
i=1 δi Pt T i

for t ≤ T0 . For a brief treatment of bootstrapping in an emerging market, we here refer to

1
The market convention is to understand the right-hand-side of (3.5) as the rate (or quote) observed at Ti−1
yy
and applied at Ti on one unit of currency giving the payoff value VTi Ti of the contract at Ti . Since this value is
yy
paid at Ti , we denote it VTi Ti , and use the subscripts Ti .

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Appendix C.1.

3.2 Discounting systems in developed markets

Next we consider the more complex case of a developed market where, in general, an OIS
market exists. In such a market, cash flows are forecast using the y-tenored IBOR zero-
coupon yield curve but discounted using the OIS zero-coupon yield curve. Such a product
feature is also consistent with the notion of collateralisation. We consider the same FRA as
in the emerging market case, however we now assume that discounting occurs under the
x-curve (or the OIS curve, to be more specific). We now have to make use of relation (2.4)
in order to define the FRA’s payoff.

Proposition 3.1. The developed market FRA with reset time Ti−1 , expiry time Ti and unit
nominal has a terminal payoff, within the x-market, given by
€ Š
xy xy y xy yy
VT T = Q T δ
T i L T (T ,
i−1 iT ) − K y
= QT VT T , (3.11)
i i i−1 i i−1 i−1 Ti i i

where, as before, δi = Ti − Ti−1 and K y is the strike rate within the y-market. The in-advance
FRA payoff is then given by
xy xy yy
VT = PTx QT VT T , (3.12)
i−1 Ti i−1 Ti i−1 Ti i i

which is the discounted value of the terminal payoff within the x-market.

Proof. A direct application of relation (2.4) leads to the result in Proposition 3.1. Like the
emerging market FRA, notice that the developed market FRA’s payoff is also measurable at
Ti−1 with the actual cash flow occurring at Ti .

Before we consider the derivation of the value of the developed market FRA, the following
lemmas will prove to be useful in this regard.

Lemma 3.1. The converted y-tenored forward IBOR process

xy xy y
L t (Ti−1 , Ti ) = Q t T L t (Ti−1 , Ti ), (3.13)
i

for t ∈ [0, Ti−1 ], satisfies the martingale relation

1 ”
x xy
—
Lsx y (Ti−1 , Ti ) = x E h L
Ti Ti−1 (T ,
i−1 iT ) Fs , (3.14)
hsx PsT
i

for 0 ≤ s ≤ t ≤ Ti−1 .

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Proof. This statement follows from Eqs (2.3), (3.13) and (3.2).

Lemma 3.2. The fair forward price K x of a forward contract initiated at time t to exchange
a cash flow K y , determined in the y-market, for a cash flow of K x , in the x-market, with K y
xy
being converted at Q T but the final payoff occurring at expiry Ti > Ti−1 ≥ t is given by
i−1 Ti

y y
h t Pt T xy
x
K = K y = QtT K y.
i
(3.15)
h tx PtxT i
i

Proof. The value of such a forward contract is given by

xy 1 ” x € y xy Š —
Vt T = x E h Ti K Q Ti−1 Ti − K
x
Ft
i ht
y
ht y
= K y
Pt T − PtxT K x , (3.16)
h tx i i

which follows from Eq. (2.3) and the tower property of conditional expectations, while
xy
setting Vt T = 0 and solving for K x yields the required result.
i

We now have the necessary results to derive the value of the developed market FRA,
which is presented in the following theorem.

Theorem 3.1. The value of the developed market FRA with reset time Ti−1 , expiry time Ti and
unit nominal, within the x-market, is given by

xy xy

Vt T = δi PtxT L t (Ti−1 , Ti ) − K x , (3.17)
i i

for t ∈ [0, Ti−1 ], where δi = Ti − Ti−1 and K x is the strike rate within the x-market.

Proof. Using Proposition 3.1, the value of the developed market FRA, for t ∈ [0, Ti−1 ], is
given by

xy 1 ” x xy
€
y
Š —
Vt T = E h P x
Q δ
Ti−1 Ti−1 Ti Ti−1 Ti i L Ti−1 (T ,
i−1 iT ) − K y
F t
i h tx
xy xy
= δi PtxT L t (Ti−1 , Ti ) − δi PtxT Q t T K y , (3.18)
i i i

with the first term following from Lemma 3.1 and the second term from Eq. (2.3). Eq.
(3.17) follows from applying the result of Lemma 3.2 to the second term and factorising
accordingly.

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 The value of this FRA is commensurate with the value of a multi-curve (or basis) FRA in
a developed market, i.e. the price dynamics are consistent with the standard FRA contract
traded in developed markets. The form of the developed market FRA’s value within the
xy-framework leads to the following definition for the multi-curve forward IBOR process.

Definition 3.1. The multi-curve market-implied y-tenored forward IBOR process is given by
xy ‚ xy Œ
xy xy y
Pt T Pt T
L t (Ti−1 , Ti ) = Q t T L t (Ti−1 , Ti ) =
i i−1
xy −1 , (3.19)
i δi PtxT Pt T
i i

xy
for t ∈ [0, Ti−1 ], where (Pt T ) is defined in Remark 1.
i

Moreover, we may also derive the fair developed market FRA rate given the value of the
FRA provided by Theorem 3.1.
xy
Corollary 3.1. The fair FRA rate process K t (Ti−1 , Ti ) at time t of a developed market FRA
written on the market-implied y-tenored forward IBOR (3.13), with reset time Ti−1 and settle-
ment time Ti , is given by
xy xy
K t (Ti−1 , Ti ) = L t (Ti−1 , Ti ), (3.20)

for t ∈ [0, Ti−1 ].

Proof. Setting the value of the developed market FRA, given by Eq. (3.17), equal to zero,
xy
we find that K x = L t (Ti−1 , Ti ) at time t. Then for any time t ∈ [0, Ti−1 ], the result for the
xy xy
fair FRA rate process, K t (Ti−1 , Ti ) = L t (Ti−1 , Ti ), follows accordingly.

Remark 3. Relation (3.20) is the direct multi-curve analogy to the single-curve relation (3.8).
In fact, for x = y one recovers the single-curve expressions (3.7) and (3.8).

Remark 4. Using Definition 3.1, one may re-state the value of the developed market FRA as

xy xy xy
Vt T = Pt T − (1 + δi K y )Pt T , (3.21)
i i−1 i

for t ∈ [0, Ti−1 ], which is the direct multi-curve analogy to the emerging market FRA value
(3.7) with the y-ZCBs replaced by the x y-ZCBs.

Now that we have these results, it is also important to consider the relationship between
xy xy
L t (Ti−1 , Ti ) and L tx (Ti−1 , Ti ). In particular, one would want L t (Ti−1 , Ti ) ≥ L tx (Ti−1 , Ti )
due to the greater degree of risk associated with the multi-curve y-tenored forward IBOR
process versus the corresponding x-tenored process. The following corollary reveals the

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conditions under which this feature is achieved, by making use of the associated forward
capitalisation factor (FCF) processes.

Corollary 3.2. The multi-curve market-implied y-tenored FCF process v tx y (Ti−1 , Ti ), observed
at time t ≤ Ti−1 and applying over the period [Ti−1 , Ti ], defined by

xy
v tx y (Ti−1 , Ti ) := 1 + δi L t (Ti−1 , Ti ) , (3.22)

is greater than or equal to the corresponding x-tenored FCF process

vtx (Ti−1 , Ti ) := 1 + δi L tx (Ti−1 , Ti ) , (3.23)

y
if interest rates are non-negative and h t ≤ h tx for all t ∈ [0, Ti−1 ] where Ti−1 ≤ Ti .

Proof. Using Eq. (3.22) and Definition 3.1, we can show that

xy y
v tx y (Ti−1 , Ti ) = 1 + δi Q t T L t (Ti−1 , Ti )
i
xy y

= 1 + Q t T vt (Ti−1 , Ti ) − 1
i
xy xy
= 1 − QtT + vt (Ti−1 , Ti ) ,
i

y xy xy y
where vt (Ti−1 , Ti ) is the y-tenored FCF and vt (Ti−1 , Ti ) := Q t T vt (Ti−1 , Ti ) is the y-
i

tenored FCF represented equivalently in the x-market. Then, using Definition 2.1 and Eq.
(2.9), we can show that
y xy
xy xy
Pt T xy
Pt T PtxT xy xy
vt (Ti−1 , Ti ) = QtT = QtT = = vtx (Ti−1 , Ti )Q t T
i−1 i−1 i−1
y xy QtT .
i
Pt T i
Pt T PtxT i−1 i−1
i i i

Now in order to have vtx (Ti−1 , Ti ) ≤ v tx y (Ti−1 , Ti ), we must have that

xy xy
vtx (Ti−1 , Ti ) ≤ 1 − Q t T + vtx (Ti−1 , Ti )Q t T
i i−1
€ Š
xy xy
x
vt (Ti−1 , Ti ) 1 − Q t T ≤ 1 − QtT
i−1 i
xy xy
1 − QtT ≤ 1 − QtT ,
i−1 i

where the last inequality holds if interest rates are non-negative, i.e. vtx (Ti−1 , Ti ) ≥ 1.
xy xy y
Finally, Q t T ≥ Q t T if interest rates are non-negative and h t ≤ h tx for all t ∈ [0, Ti−1 ]
i−1 i

where Ti−1 ≤ Ti . This may be easily evidenced by setting t = Ti−1 and allowing Ti to vary,
while also using the linear and monotonic properties of conditional expectations.

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 This corollary proves that the xy-approach, applied to a developed market, yields a y-
y
market interest rate system which is dominated by the x-market system, i.e. Pt T ≤ PtxT
for 0 ≤ t ≤ T . Furthermore, this y-market system provides a forward IBOR process,
y xy
L t (Ti−1 , Ti ), and enables the construction of a conversion factor process Q t T , which facili-
i
xy
tates the definition of the developed market y-tenored forward IBOR process L t (Ti−1 , Ti ).
Therefore, while the y-market system is still fictitious, given that it cannot be directly ob-
served, we still consider it to be a model-consistent system given our curve-conversion
framework that is inspired by currency modelling.

Remark 5. Using the FCF, one may also express the terminal payoff of the developed market
FRA by
€ Š
xy xy y y
VT T = Q T vT (Ti−1 , Ti ) − vK , (3.24)
i i i−1 Ti i−1

y
where vK := (1 + δi K y ). Then, applying the same results as before, the value of the FRA, for
t ∈ [0, Ti−1 ], is
xy xy

Vt T = PtxT vt (Ti−1 , Ti ) − vKx , (3.25)
i i

xy y
where vKx = Q t T vK . If we define the multi-curve y-tenored forward IBOR process by
i

xy 1 xy

L t (Ti−1 , Ti ) := vt (Ti−1 , Ti ) − 1 , (3.26)
δi

and the multi-curve x-market equivalent FRA strike rate by

x 1 x

K := vK − 1 , (3.27)
δi

xy xy x

we then recover the developed market FRA price process: Vt T = PtxT δi L t (Ti−1 , Ti ) − K .
i i
xy xy
We note that in this model vt (Ti−1 , Ti ) = vtx (Ti−1 , Ti )Q t T so that
i−1

xy y y
1 + δi L t (Ti−1 , Ti ) h t Pt T
=
i−1
, (3.28)
1 + δi L tx (Ti−1 , Ti ) h tx PtxT
i−1

xy y
and L t (Ti−1 , Ti ) ≥ L tx (Ti−1 , Ti ) if interest rates are non-negative and h tx ≤ h t for all t ∈
[0, Ti−1 ] and for Ti−1 ≤ Ti . This is the approach adopted by Nguyen & Seifried [44] and it
shall be revisited in Section 5. Two comments on their multi-curve model, given the context of
the xy-approach, follow:
xy x
(i) The quantities L t (Ti−1 , Ti ) and K which determine the FRA’s floating and fixed cash
xy
flows are derived from the curve-converted quantities vt (Ti−1 , Ti ) and vKx respectively.

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 xy
This is in contrast with L t (Ti−1 , Ti ) and K x , the directly comparable curve-converted
quantities used in the xy-framework. Therefore, these derived quantities are no longer
consistent with a currency modelling analogy, with each differing from the correctly con-
xy
verted quantities by an additive factor of (Q t T − 1)/δi .
i

(ii) Observation (i) is further supported by equation (3.28) which shows that the conver-
sion factor process effectively models the spread between the multi-curve y-tenored FCF
and the corresponding x-tenored FCF, as opposed to the classical forward exchange rate.
Moreover, the derived y-market system has almost no relation to the developed market
y-tenored interest rate system, that one seeks to model, since the model derived y-market
y
system dominates the x-market system, i.e. PtxT ≤ Pt T for 0 ≤ t ≤ T .

Remark 6. The mathematical quantity that directly models the y-tenored forward IBOR pro-
xy y
cess is L· (·, ·) and not L· (·, ·). This is a consequence of industry standards in developed mar-
kets, that the product of the x-pricing kernel and the x-curve discounted y-tenored forward
IBOR process is a martingale under the P-measure. In the x y-approach, this implies that
” —
y
x
hsx PsT Lsy (Ti−1 , Ti ) = E h tx PtxT L t (Ti−1 , Ti ) | Fs , (3.29)
i i

for 0 ≤ s ≤ t ≤ Ti−1 . It is not possible to achieve this relationship within the xy-framework,
given our representation of the y-tenored forward IBOR process (3.4). However this relation-
y xy
ship is achieved if we replace L· (·, ·) with L· (·, ·). Our market-implied y-tenored forward
xy
IBOR process, L· (·, ·), reveals the convolution of a conversion factor (which facilitates the mar-
y
ket’s martingale assumption (3.29)) and the model y-tenored forward IBOR process, L· (·, ·).
This result questions the utility of the y-ZCB system in the developed market context. The y-
ZCB system is a model construct, derived from the y-tenored model-consistent or model-implied
y
forward IBOR process, L· (·, ·), which unravels the market’s martingale adjustment from the ob-
xy yx
served y-tenored market-implied IBOR process, L· (·, ·), via the conversion factor Q ·· .

Remark 7. The xy-framework advocates the following price process for a multi-curve FRA

xy xy y

Vt T = δi Pt T L t (Ti−1 , Ti ) − K y , (3.30)
i i

for t ∈ [0, Ti ]. We note that the conversion factor (or martingale adjustment) has been applied
to the discounting x-ZCB system and not to the model for the y-tenored forward IBOR process.

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However, we note that the terminal FRA payoff would now be
y
xy
hT € y
Š
= δi L T (Ti−1 , Ti ) − K y .
i
VT T
i i h Tx i−1
i

This allows us to disentangle the y-ZCB system from the x-ZCB system, which enables us to
model the y-curve discounting in a consistent, robust and rigorous fashion. From an economics
perspective, if one compares the return generated from an xy-FRA to a yy-FRA, one can show
that yy xy xy
Vt T Vt T Vt T
> =
i i i
yy xy yy , (3.31)
V0T V0T V0T
i i i

as required, since discounting at the x-curve essentially represents a collateralised FRA which
should therefore return the holder less than an equivalent investment in a non-collateralised
FRA, represented by the y-curve discounting.

Next we consider the developed market IRS, i.e. one which forecasts cash flows under
the y-curve but discounts under the x-curve, unlike the emerging market IRS.

Theorem 3.2. The value of a developed market IRS, within the x-market, with reset times
{T0 , T1 , . . . , Tn−1 }, payment times {T1 , T2 , . . . , Tn } and unit nominal, referencing the y-tenored
IBOR is given by
n
X
xy xy

Vt T = δi PtxT L t (Ti−1 , Ti ) − S x , (3.32)
n i
i=1

for t ≤ T0 , where δi = Ti − Ti−1 and where S x is the fixed swap rate within the x-market.

Proof. Starting with the emerging market version of the IRS with fixed swap rate S y within
the y-market and applying pricing relation (2.4), analagous to Proposition 3.1, the developed
market IRS price process is given by

n
xy
X δi ” x xy
€
y
Š —
Vt T = x
x E h Ti−1 PTi−1 Ti Q Ti−1 Ti L Ti−1 (Ti−1 , Ti ) − S
y
Ft , (3.33)
n h
i=1 t

which, upon application of Lemma 3.1 and Equation (2.3), simplifies to

n
X € Š
xy xy xy
Vt T = δi PtxT L t (Ti−1 , Ti ) − Q t T S y , (3.34)
n i i
i=1

for t ≤ T0 . The result follows by observing that the fixed IRS rate may be expressed in the
Pn xy Pn
x-market by S x = S y ( i=1 δi PtxT Q t T )/( i=1 δi PtxT ). This may be justified in an analogous
i i i

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fashion to the fixed FRA rate, but this time making use of a fixed-for-fixed swap contract as
opposed to a forward contract, as in Lemma 3.2.

Remark 8. Using Definition 3.19, one may re-state the value of the developed market IRS as

” — n
X
xy xy xy xy
Vt T = Pt T − Pt T − S y δi Pt T , (3.35)
n 0 n i
i=1

for t ≤ T0 , which is the direct multi-curve analogy to the emerging market IRS value (3.9) with
the y-ZCBs replaced by the x y-ZCBs.
xy
Corollary 3.3. The fair fixed swap rate process S t (T0 , Tn ) of a developed market IRS written
on the market-implied y-tenored forward IBOR (3.13), with reset times {T0 , T1 , . . . , Tn−1 },
payment times {T1 , T2 , . . . , Tn } and unit nominal, is given by
xy xy
xy
Pt T − Pt T
S t (T0 , Tn ) = Pn
0 n
, (3.36)
δ P x
i=1 i t T i

for t ≤ T0 .

Proof. Setting the value of the developed market IRS equal to zero, given by Eq. (3.35), it
€ Š P
xy xy n xy
follows that the y-market fair fixed IRS rate is S y = Pt T − Pt T / i=1 δi Pt T at time t.
0 n i

Using the proof of Theorem 3.2 and Remark 1, the x-market fair fixed IRS rate (converting
Pn xy Pn
the y-market rate) is given by S x = S y ( i=1 δi PtxT Q t T )/( i=1 δi PtxT ) at time t. Then for
i i i

any time t ≤ T0 , the result for the developed market fair IRS rate follows accordingly by
xy
setting S t (T0 , Tn ) = S x .

For a brief treatment of bootstrapping in a developed market, we here refer to Appendix

C.2.

3.3 Consistent multi-curve discounting in emerging markets

Now that we have a good understanding of how the xy-formalism enables the modelling of
multi-curve interest rate systems in developed markets, we may consider resolving the same
problem for the case of an emerging market. Our first hurdle in moving from a developed to
an emerging market setting is the non-existence of the OIS curve.
Recall that we have assumed the existence of a collection of interest rate curves indexed
by x, y = 0, 1, 2, . . . , n where we refer to the x-curve as the discounting curve and the y-
curve as the forecasting curve. In a common developed market, n = 4 with 0 denoting the

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nominal OIS curve, 1 the 1-month IBOR curve, 2 the 3-month IBOR curve, 3 the 6-month
IBOR curve and 4 the 12-month IBOR curve. Moreover, the stochastic evolution of each
y
of these curves are modelled via a pricing kernel process (h t ) which are in turn calibrated
using liquid linear and non-linear interest rate market instruments. In a common emerging
market, only one IBOR tenor is usually tradable and liquid, therefore it is not possible to
y
calibrate the entire set of pricing kernel processes (h t ) which span the common developed
interest rate market. This leads us to the following remark.

Remark 9. In the common emerging market, only one IBOR tenor, y ∗ , is tradable and liquid
y∗
thereby enabling the specification and calibration of a well-defined pricing kernel process (h t ).
y
Pricing kernel processes for all other IBOR tenors (b h ) are to be estimated statistically (or
t
y∗
otherwise) as a suitable functional form of (h t ), i.e.
€ ∗Š
y y
ht = f ht .
b (3.37)

where f : R+ → R+ is measurable and adapted, such that the corresponding estimated y-ZCB
b y ), may be constructed via
(and y-curve) systems, ( P tT

1 b y 1 ” € ∗Š —
by = y

PtT y
E h T | F t = y∗
E f h T | F t , (3.38)
ht
b f ht

for 0 ≤ t ≤ T .

In Remark 9, if the function f (·) is linear, then the estimated y-ZCB is given by

1 € ∗Š
by =
P f
y
Pt T , (3.39)
tT y∗

f ht

which implies that it is possible to directly replicate the estimated y-ZCB through either a
static or dynamic replication strategy using the y ∗ -ZCB. However, this may not be possible,
in general, if the function f (·) is convex (concave), as the estimated y-ZCB will be governed
by the following inequality
1 € ∗Š
b y ≥ (≤)
P
y

f Pt T , (3.40)
tT y∗
f ht
which follows by the application of Jensen’s inequality. The xy-formalism may now be ap-
plied in the emerging market setting, assuming the existence of a collection of interest rate
curves, indexed by x, y = 0, 1, . . . , y ∗ , . . . , n, that are modelled by the calibrated pricing
y∗ y
kernel process (h ) and the set of estimated pricing kernel processes (b
t h ; y 6= y ∗ ). First,
t
we consider the developed market FRA within the emerging market context, i.e. one where

22

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the payoff is forecasted by the y-curve and then discounted by the x-curve. The terminal
and in-advance FRA payoffs remain unchanged and are identical to Eqs (3.11) and (3.12),
respectively2 , with the FRA price process also assuming the familiar form

xy xy y

Vt T = δi Pt T L t (Ti−1 , Ti ) − K y
i i
xy xy
= Pt T − (1 + δi K y )Pt T , (3.41)
i−1 i

y
for t ∈ [0, Ti−1 ], while L t (Ti−1 , Ti ) continues to be the correct forward IBOR process. Notice
that the derivation of equation (3.41) follows by a direct application of Corollary 2.1.

Definition 3.2. The multi-curve emerging market y-tenored forward IBOR process is given by
‚ y Œ
y 1 Pt T
L t (Ti−1 , Ti ) =
i−1
y −1 , (3.42)
δi Pt T
i

for t ∈ [0, Ti−1 ], unlike the developed market which required the definition of the market-
xy xy y
implied y-tenored forward IBOR process L t (Ti−1 , Ti ) := Q t T L t (Ti−1 , Ti ) for t ∈ [0, Ti−1 ].
i

This is due to the fact that there is currently no market standard for pricing an emerging
market FRA that is forecasted and discounted under different curves, with the only observ-
y
able market quantity being the spot IBOR process L t (t, t + δ) for t ≥ 0. It is also possi-
xy
ble, as in the case of developed markets, to define a fair FRA rate process, K t (Ti−1 , Ti ) =
y
L t (Ti−1 , Ti ), however one would not be able to observe this quantity in the market (since
these FRAs are not traded, in general), therefore this would be a model-implied quantity3 .
Similarly, we may consider the standard developed market IRS in the context of an emerg-
ing market. The value of the IRS at some time t ≤ T0 , making use of the same relations as
before, is again given by

n
X
xy xy y

Vt T = δi Pt T L t (Ti−1 , Ti ) − S y
n i
i=1
n
X
xy xy xy
= Pt T − Pt T − S y δi Pt T , (3.43)
0 n i
i=1

y
where L t (Ti−1 , Ti ), for t ∈ [0, Ti−1 ], continues to be the correct forward IBOR process,
analagous to the FRA result. As with the FRA, the fair IRS rate process is model-implied
2
Assuming that one insists on maintaining measurability of the payoff at the IBOR reset time Ti−1 .
If the y-tenored IBOR corresponds to the most liquid and tradable tenor, i.e. y = y ∗ , then one will also
3
y
have access to the set of forward IBOR processes L t (Ti−1 , Ti ) for 0 ≤ t ≤ Ti−1 , from the standard and liquidly
xy yy y
tradable set of single-curve emerging market FRAs, and K t (Ti−1 , Ti ) = K t (Ti−1 , Ti ) = L t (Ti−1 , Ti ).

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(unless the y-tenored IBOR process is the tradable tenor and t = T0 = 0) and given by
xy xy xy Pn xy
S t (T0 , Tn ) = (Pt T − Pt T )/( i=1 δi Pt T ) for t ≤ T0 .
0 n i

In a multi-curve emerging market interest rate system, within the xy-framework, the ini-
tial (estimated) y-ZCB systems may be constructed in a completely analogous fashion to the
xy y
single-curve emerging market relations, see Appendix C, since K0 (Ti−1 , Ti ) = L0 (Ti−1 , Ti )
xy y Pn y
and S0 (0, Tn ) = (1 − P0T )/( i=1 δi P0T ). That is, all initial model-implied quantities are
n i

only dependent on the y-curve or y-ZCB system.

If we consider a FRA and an IRS within this context with payoffs forecasted by the y ∗ -
curve and discounted by one of the other curves, denoted by the x-curve, then the pricing
formulae are given by
x y∗ x y∗ ∗ x y∗
Vt T = Pt T − (1 + δi K y )Pt T , (3.44)
i i−1 i

and
n
x y∗ x y∗ x y∗ x y∗
” — X
Vt T = Pt T − Pt T − S y δi Pt T , (3.45)
n 0 n i
i=1

from Eqs (3.41) and (3.43), respectively. At this juncture, it is important to note that the
x y∗ y∗
x y ∗ -ZCB, (Pt T ), plays the same role as the y ∗ -ZCB, (Pt T ), does in the single-curve emerging
market setting in Section 3.1. This leads us to the following definition for the x y-ZCB
system, in general.

Definition 3.3. In the multi-curve interest rate system derived within the xy-framework, the
xy
x y-ZCB system, (Pt T ), defined by
  y 
xy 1 hT xy xy y
Pt T x
= x E hT (1) F t = PtxT Q t T = Q t t Pt T ,
ht h Tx

may be considered to be a quanto-bond assuming

xy
(i) the x-curve with varying notional defined by the forward conversion factor Q t T ; or
xy
(ii) the y-curve with varying notional defined by the spot conversion factor Q t t .

Remark 10. Within the developed market context—where the nominal OIS curve is considered
to be the distinct, single-curve tradable system, which we shall denote here as the x ∗ -curve—
one may dynamically replicate y-ZCBs and x ∗ y-ZCBs, where y 6= x ∗ , via the following set of
x ∗ -curve quanto-bonds
x∗ y
y QtT ∗ x∗ y x∗ y ∗
Pt T = x∗ y
PtxT and Pt T = Q t T PtxT ,
Qtt

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whereas, within the emerging market context where one nominal IBOR swap curve is considered
to be the distinct, single-curve tradable system, which we have denoted as the y ∗ -curve, one may
dynamically replicate x-ZCBs and x y ∗ -ZCBs, where x 6= y ∗ , via the following set of y ∗ -curve
quanto-bonds
x y∗
Qtt y∗ x y∗ x y∗ y∗
PtxT = x y∗
Pt T and Pt T = Q t t Pt T .
QtT

4 xy-HJM multi-curve models

In this section we develop Heath-Jarrow-Morton (HJM) multi-curve interest rate systems

based on the xy-formalism introduced in this paper. The xy-HJM multi-curve system will be
derived using results from Section 3.
We consider the filtered probability space (Ω, F , (F t ), P) where (F t )0≤t is the filtration
generated by two sets of independent multi-dimensional P-Brownian motions (Wt ) t≥0 and
(Z t ) t≥0 , respectively. Being synonymous with the xy-formalism, we consider an economy
with two distinct markets, x and y, where x may be interpreted as a proxy default-free OIS-
based market and y as a risky IBOR-based market. Furthermore, we assume that the x- and
y-markets are driven by the multi-dimensional P-Brownian motions (Wtx ) t≥0 = (Wt ) t≥0
y
and (Wt ) t≥0 = (Wt , Z t ) t≥0 respectively, where (Wt ) t≥0 is n-dimensional and (Z t ) t≥0 is m-
dimensional. This allows us to define the pricing kernel process associated with each market.
y
Definition 4.1. The (F t )-adapted x- and y-market pricing kernel processes (h tx )0≤t and (h t )0≤t
satisfy, respectively,
y
dh tx dh t y y y
= −r tx dt − λ tx dWtx , y = −r t dt − λ t dWt , (4.1)
h tx ht

y y
where (r tx ) t≥0 and (r t ) t≥0 are the short rates of interest; and (λ tx ) t≥0 and (λ t ) t≥0 = (λ tx , λzt ) t≥0
are the n- and (n + m)-dimensional market price of risk processes associated with the x- and
y-markets, respectively.

Next, let (X t T )0≤t≤T and (Yt T )0≤t≤T be (well-defined) processes, respectively satisfying

dX t T 1 x 2
 ‹

x
= −A t T + Σ t T dt − Σ txT + λ tx dWtx ,
XtT 2
dYt T 1 y 2
 ‹
y y y
y
= −A t T + Σ t T dt − Σ t T + λ t dWt , (4.2)
Yt T 2

(·) (·)
RT
for 0 ≤ t ≤ T , where A t T = t
a tu du is 1-dimensional, | · | denotes the Euclidean norm,

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 (·) (·)
RT y
and Σ t T = t
σ tu du with Σ txT and Σ t T being n- and (n + m)-dimensional, respectively. The
y (·)
t T , σ t T ) and (a t T ) are generic adapted processes satisfying the
processes (σ txT ), (σ t T ) = (σ w z

implicit integrability conditions, with σ w t T and σ t T being n- and m-dimensional, respectively.

z

We may then define the respective ZCB prices as follows:

y y
Definition 4.2. Setting PtxT := X t T /h tx and Pt T := Yt T /h t , the (F t )-adapted x- and y-market
ZCB-systems satisfy, respectively, the dynamical equations

dPtxT 1
 ‹
2
= r tx − AxtT + Σ txT − λ tx Σ txT dt − Σ txT dWtx ,
PtxT 2
y
dPt T 1 y
 ‹
y y 2 y y y y
y = rt − At T + Σ − λ t Σ t T dt − Σ t T dWt , (4.3)
Pt T 2 tT

(·)
following the application of Ito’s Lemma. Invoking the classical HJM drift condition, A t T =
1 (·) 2 (·) (·)
2 |Σ t T | , results in (h t Pt T )0≤t≤T being a P-(local) martingale which is a requirement for the
xy-HJM framework.

Proposition 4.1. Assuming that the x- and y-market ZCB-systems are differentiable in T ,
y
the instantaneous forward rate processes ( f txT )0≤t≤T and ( f t T )0≤t≤T , respectively defined by

y y

f txT = −∂ T ln PtxT and f t T = −∂ T ln Pt T , satisfy

d f txT = a txT + λ tx σ txT dt + σ txT dWtx ,
y y y y
y y
d ft T = a t T + λ t σ t T dt + σ t T dWt , (4.4)

which are consistent with the classical HJM instantaneous forward rate model.

Proof. By direct application of Ito’s Lemma, the logarithm of the ZCB price process is
Z t Z t
(·) (·) (·) (·) (·)
€ Š € Š € Š
ln Pt T = ln P0T + rs − AsT − λ(·)
s ΣsT ds − ΣsT dWs(·) , (4.5)
0 0

and therefore taking the negative and differentiating with respect to T gives

t t
∂
Z Z
(·) (·) (·) (·)
€ Š € Š
− ln Pt T = asT + λ(·)
s σsT ds + σsT dWs(·) , (4.6)
∂T 0 0

which yields the required instantaneous forward rate result.

Grbac & Runggaldier [23] provide a thorough account of the approaches that have been
adopted in modeling a developed market multi-curve interest rate system with the HJM

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framework. Here we reprise the key results, given the economy that has already been in-
troduced in this section, in order to contextualise the xy-HJM framework within the ex-
isting body of literature. Grbac & Runggaldier [23] note that all approaches that have
been adopted model the x-market ZCB-system (PtxT ) with the classical HJM model while
the multi-curve market-implied y-tenored forward IBOR process, which we denote here by
xy
L t (Ti−1 , Ti ), is modeled in one of three ways:
xy
(i) L t (Ti−1 , Ti ) is specified in an ad hoc fashion (usually) inspired by the LIBOR Market
Model (LMM) such that this approach is referred to as a hybrid HJM-LMM;
xy y y y y
(ii) L t (Ti−1 , Ti ) := (vt (Ti−1 , Ti ) − 1)/δi where, as before, vt (Ti−1 , Ti ) := Pt T /Pt T
i−1 i

defines the FCF such that under certain parameter restrictions (see Proposition 4.2
y
below) (h tx PtxT vt (Ti−1 , Ti ))0≤t≤Ti−1 is a P-(local) martingale; and
i

xy y
(iii) L t (Ti−1 , Ti ) := E[h Tx L T (Ti−1 , Ti ) F t ]/(h tx PtxT ) assuming the classical HJM drift
i i−1 i

condition for the y-market ZCB system.

xy
In each approach (h tx PtxT L t (Ti−1 , Ti ))0≤t≤Ti−1 is a P-(local) martingale, as required. Model
i

(i) is inconsistent with our approach, since our focus is on modeling ZCB-systems directly
and implying simple spot and forward rate models therefrom, therefore we merely make
note of (i) for completeness. Models (ii) and (iii) are comparable to our approach, therefore
we expand upon them below.

Proposition 4.2. If the following parameter restrictions hold:

1 y 2 € Š € Š
y y y
At T − At T =− Σ − Σt T + Σ txT ΣwtT − ΣwtT − λzt Σzt T − Σzt T , (4.7)
i i−1 2 t Ti i−1 i i i−1 i i−1

y
then the process (h tx PtxT vt (Ti−1 , Ti ))0≤t≤Ti−1 a P-(local) martingale, thereby enabling the use
i

of Model (ii).
y
Proof. Applying Ito’s Lemma to h tx PtxT vt (Ti−1 , Ti ), using Eqs (4.1) and (4.3), we have
i

€ Š
y
d h tx PtxT vt (Ti−1 , Ti )
i
y
h tx PtxT vt (Ti−1 , Ti )
i

1 y 2
• € Š € Š˜
y y y
= At T − At T + Σt T − Σt T − Σ txT ΣwtT − ΣwtT + λzt Σzt T − Σzt T dt
i i−1 2 i i−1 i i i−1 i i−1
€ Š € Š
+ ΣwtT − ΣwtT − Σ txT − λ tx dWtx + Σzt T − Σzt T dZ t , (4.8)
i i−1 i i i−1

from which it follows that the required martingale condition is achieved only if Eq. (4.7) is
enforced.

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Remark 11. In Grbac & Runggaldier [23], both the x- and y-markets have the same sources
of risk, i.e. are driven by the same set of Brownian motions, which resolves the parameter
restrictions to

y y 1€ y y
Š2 €
y y
Š
At T − At T =− Σt T − Σt T + Σ txT Σ t T − Σ t T , (4.9)
i i−1 2 i i−1 i i i−1

for 0 ≤ t ≤ Ti−1 .
y
Model (iii) requires one to compute a conditional expectation, E[h Tx L T (Ti−1 , Ti ) F t ],
i i−1

which is possible given our model choices, i.e. Eqs (4.1) and (4.3), along with the classical
HJM drift condition applied to the y-market ZCB-system. Note that in Grbac & Runggaldier
[23], this model is justified by analogies to credit and foreign exchange modeling. Their
model setup leads to two different parameter restrictions, depending on which analogy is
assumed. Our pricing kernel-based HJM setup leads to a unique parameter restriction (the
classical HJM drift condition for the y-market ZCB-system) which subsumes both analo-
gies, since our setup does not require us to specify an exchange rate process in an ad hoc
exogenous manner. This may be seen in the following proposition, recalling the results from
Proposition 2.1.
xy
Proposition 4.3. The xy-HJM framework’s forward curve-conversion factor process (Q t T )0≤t≤T
satisfies
xy
dQ t T
xy = (Σ txT − ΣwtT )(Σ txT dt + λ tx dt + dWtx ) − (Σzt T + λzt )dZ t , (4.10)
QtT
xy
while the spot curve-conversion factor process (Q t t ) t≥0 satisfies

xy
dQ t t y
y y
xy = r tx − r t dt + λ tx dWtx − λ t dWt , (4.11)
Qtt

y y
where λ tx dWtx − λ t dWt = −λzt dZ t .

Proof. Using the definition of the conversion factor, Eq. (2.3), along with Definition 4.2, ob-
xy xy y
serve that Q t T = Yt T /X t T while Q t t = h t /h tx . The result then follows by a straightforward
application of Ito’s Lemma using Eqs. (4.2) and (4.1).

Remark 12. By the Girsanov Theorem, it is straightforward to show that there is a multi-
dimensional Q x -Brownian motion (Wt x ) that satisfies dWt = λ tx dt + dWtx upon changing
Q Qx

measure from P to the x-market risk-neutral measure Q x . Moreover there is also a multi-
QT Q Tx
dimensional Q Tx -Brownian motion (Wt x ) that satisfies dWt = Σ txT dt +dWt
Qx
upon changing
measure from Q x to the x-market T -forward measure Q Tx .

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 In this paper we have proposed the xy-formalism for multi-curve interest rate modeling,
and in turn advocated model structures for both multi-curve emerging and developed mar-
ket forward IBOR processes (see Definitions 3.2 and 3.1, respectively). We document these
multi-curve forward IBOR processes within the xy-HJM context in the next definition.

Definition 4.3. Within the xy-HJM framework, the multi-curve emerging market y-tenored
forward IBOR process is given by

y 1 y

L t (Ti−1 , Ti ) = vt (Ti−1 , Ti ) − 1 , (4.12)
δi
y
with the FCF process, vt (Ti−1 , Ti ), satisfying

y
dvt (Ti−1 , Ti ) €
y y
Š€
y y y
Š
y = Σt T − Σt T Σ t T dt + λ t dt + dWt , (4.13)
vt (Ti−1 , Ti ) i i−1 i

y y y
for 0 ≤ t ≤ Ti−1 , such that the process (h t Pt T vt (Ti−1 , Ti ))0≤t≤Ti−1 is a P-(local) martingale.
i

The multi-curve developed market y-tenored forward IBOR process is given by

xy xy y 1 € xy xy
Š
L t (Ti−1 , Ti ) = Q t T L t (Ti−1 , Ti ) = vt (Ti−1 , Ti ) − Q t T , (4.14)
i δi i

xy xy y
with the converted FCF process, vt (Ti−1 , Ti ) := Q t T vt (Ti−1 , Ti ), satisfying
i

xy
dvt (Ti−1 , Ti ) € Š€ Š
xy = Σ txT − ΣwtT Σ txT dt + λ tx dt + dWtx − (Σzt T + λzt )dZ t , (4.15)
vt (Ti−1 , Ti ) i i−1 i i−1

xy
for 0 ≤ t ≤ Ti−1 , such that the process (h tx PtxT vt (Ti−1 , Ti ))0≤t≤Ti−1 is a P-(local) martingale.
i

xy
We note that (h tx PtxT L t (Ti−1 , Ti ))0≤t≤Ti−1 is also a P-(local) martingale, however the
i

multi-curve developed market y-tenored forward IBOR process does not have an elegant
differential representation as it is essentially the difference between two stochastic pro-
cesses, these being the converted FCF process and the curve-conversion factor process.

Remark 13. The only parameter restrictions required by the xy-HJM framework are the clas-
sical HJM drift conditions for both the x- and y-market ZCB systems. Therefore model (iii), as
presented in Grbac & Runggaldier [23], is also a viable model for the developed market forward
IBOR process, albeit an unnatural one given the incompatibility between the x-market pricing
y
kernel (h tx ) and the y-market forward IBOR process (L t (Ti−1 , Ti )). Another viable model
within the xy-HJM framework is that of Nguyen & Seifried [44], given by equation (3.26),
however recall the observations in Remark 5 regarding this model.

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 In the next section, rational multi-curve models are introduced. Such models, and in
particular those produced in Section 5.2, provide a rich class of flexible and tractable spec-
ifications for xy-HJM multi-curve models and associated spread dynamics.

5 Rational multi-curve models

As reported in Grbac & Runggaldier [23], multi-curve rational interest rate models based on
the pricing kernel approach have appeared in Crépey et al. [11] and in Nguyen & Seifried
[44]. The multi-curve approach proposed by Crépey et al. [11] assumes a discount bond
system associated with an overnight-indexed swap (OIS) market and introduces a (forward)
LIBOR process that has a built-in spread when compared to the OIS rate. The OIS-based
discount bond price system, which in our setup would correspond to the x-curve ZCB price
system, is generated by pricing kernel models driven by stochastic factors. The (forward)
LIBOR process is derived by pricing a forward rate agreement (FRA) written on the LIBOR.
The factor-based model of the multi-curve (forward) LIBOR process is then deduced from
the no-arbitrage relation the FRA price process is required to satisfy. The LIBOR model turns
out to be a rational function(al) of stochastic drivers that is given in units of the OIS pricing
kernel proxy. Thus, whenever the LIBOR dynamics depend on an idiosyncratic driving factor
(not affecting the OIS pricing kernel proxy), an OIS-LIBOR spread is generated that depends
on a spread-idiosyncratic stochastic factor. The source of the spread can be readily read
off from the expression of the LIBOR model owing to the transparency of the multi-curve
approach brought forward. Given that the OIS-LIBOR spread is obtained by focusing on how
the offer rate is modelled, we refer to Crépey et al. [11], and also the Nguyen & Seifried
[44], as a rate-based modelling approach.

5.1 Hybrid rational-LMM multi-curve models

A feature that is rather telling in understanding the structure of multi-curve models, and
thus helps in their classification, is the nature of the discount and the forecasting curve,
respectively. In the multi-curve models by Crépey et al. [11], the term-structure of the
discount (OIS-based) curve is constructed by a rational model. However, the LIBOR model
is postulated in a rather ad-hoc manner and ensues directly from modelling the payoff of the
forward rate agreement written on it. Similar to the hybrid HJM-LMM models in Section 4,
the forecasting curve (i.e. LIBOR-based term structure) is constructed akin to LIBOR market
models. This is why we refer to Crépey et al. [11], and to some extent also to Nguyen &

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Seifried [44], as rational-LMM hybrid models. Next, we establish the relations between these
models and the framework presented in this paper.

Proposition 5.1. Let K(t; Ti−1 , Ti ) be the value at time t ∈ [0, Ti−1 ] of the fair FRA rate
xy
obtained in Crépey et al. [11], Section 2.1. Then it holds that K(t; Ti−1 , Ti ) = K t (Ti−1 , Ti ),
xy
where K t (Ti−1 , Ti ) is determined by Eq. (3.20).

Proof. By setting Pt Ti = PtxT , it follows that

i

xy xy y
L(t; Ti−1 , Ti ) = PtxT L t (Ti−1 , Ti ) = Pt T L t (Ti−1 , Ti ), (5.1)
i i

where L(t; Ti−1 , Ti ) is the LIBOR specified in Crépey et al. [11], Eq. (2.6).

Furthermore, in Section 2.2 of Crépey et al. [11], a particular class of rational LIBOR
models is presented that becomes the workhorse, later in the paper. Next we show how
such class is obtained within the x y-framework.
y y y
Remark 14. From the relation (5.1) and by recalling that Pt T = E[h T |F t ]/h t , we deduce
i i

that
1 € ” y — ”
y
—Š
L(t; Ti−1 , Ti ) = x E h Ti−1 F t − E h Ti F t . (5.2)
δi h t
Next we specify the discounting and forecasting kernels as follows:

(1)
x
h tx = P0t + b1 (t) A t , (5.3)
y y (2) (3)
h t = P0t + b̄2 (t) A t + b̄3 (t) A t , (5.4)

(i) y
where, for i = 1, 2, 3, the processes (A t ) are martingales. The quantities P0t
x
, P0t , b1 (t) and
b̄i (t), i = 2, 3, are suitably chosen deterministic functions. The correspondence to the rational
multi-curve LIBOR models by Crépey et al. [11], Section 2.2, is found by setting

1 € y y
Š
L(0; Ti−1 , Ti ) = P0T − P0T ,
δi i−1 i

1   1  
b2 (Ti , Ti−1 ) = b̄2 (Ti−1 ) − b̄2 (Ti ) , b3 (Ti , Ti−1 ) = b̄3 (Ti−1 ) − b̄3 (Ti ) . (5.5)
δi δi

The specifications (5.5) cause a slight loss of generality. However, whether in practical terms
such specifications are indeed restrictive can be decided once this model class is calibrated to
actual market data.

We now turn our attention to the rational multi-curve models presented in Nguyen &
Seifried [44]. They propose to make use of the so-called FX-analogy to motivate pricing

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kernel models for the spread observed between the OIS rate and LIBOR. In particular in
Section 4, Theorem 4.1, a multiplicative spread is considered. The spread is given by the
ratio of a conditional expectation of the OIS-based pricing kernel (state-price deflator) and
a conditional expectation of a hypothetical pricing kernel. The latter deflator may be asso-
ciated with a foreign currency, although they distance themselves from such an interpreta-
tion, c.f. Section 4.2 of Nguyen & Seifried [44]. It is our view that, although the OIS-LIBOR
spread is interpreted as a kind of currency exchange rate in their work, the deduced rational
multi-curve LIBOR models are of the kind that Crépey et al. [11] derive. This is especially
so because the rational LIBOR models developed in Nguyen & Seifried [44] are rate-based
models—just as those produced by Crépey et al. [11]—which relate the OIS forward rate
and LIBOR, directly. As they seek to dissociate themselves from the work of Bianchetti [5],
who, among other authors, unequivocally sticks to the FX-analogy, we show that the ratio-
nal models in Nguyen & Seifried [44] do not need to rely on the FX-analogy in order to be
derived within a pricing kernel setup.

Proposition 5.2. In Nguyen & Seifried [44], the multi-curve fair FRA rate L ∆ (t; T, T + ∆) is
given by ‚  ∆  Œ
1 p(t, T ) E DT | F t
L ∆ (t; T, T + ∆) = −1 , (5.6)
∆ p(t, T + ∆) E [DT | F t ]

for t ∈ [0, T ]. This model can be obtained by the following specification of the LIBOR process
(L(t; Ti−1 , Ti ))0≤t≤Ti−1 , for i = 1, 2, . . . , n, in Crépey et al. [11], Section 2.1, Eq. (2.7):

1
E DT∆ | F t − E [DT +∆ | F t ] ,
 

L(t; Ti−1 , Ti ) = (5.7)
∆Dt

where Ti−1 = T and Ti = T + ∆.

Proof. Relation (5.7) is directly obtained by equating the fair FRA rate (4.2) in Nguyen &
Seifried [44] with the fair FRA rate (2.7) in Crépey et al. [11]. This shows that the OIS-
LIBOR spread models, given in Theorem 4.1 in Nguyen & Seifried [44], do not necessitate
the use of the FX-analogy in order to derive (rate-based) multi-curve discounting models
in a pricing kernel approach. While (Dt ) corresponds to the OIS-associated pricing kernel
process (π t ) in Crépey et al. [11], there is indeed no reason to identify the process (Dt∆ )
with a fictitious pricing kernel associated with a foreign currency/economy. It may just be
viewed as an idiosyncratic component of the LIBOR process.

Remark 15. Comparing Eq. (5.7) with Eq. (5.2) we observe a discrepancy in the way that
the conversion to a multi-curve setup is obtained in Nguyen & Seifried [44]. The source of

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such incongruence is discussed in Remark 5, (i). The difference is resolved by the following
adjustment in the multi-curve model (5.6):
‚  ∆  Œ
∆ 1 p(t, T ) E DT | F t
L (t; T, T + ∆) = − 1 · Q(t, T + ∆) , (5.8)
∆ p(t, T + ∆) E [DT | F t ]

where, based on to the x y-approach, the conversion factor Q(t, T + ∆), or spread process, is
given by
E DT∆+∆ | F t
 
Q(t, T + ∆) = . (5.9)
E [DT +∆ | F t ]
The adjustment allows the model to be derived by a consistent application of the FX-analogy in
a pricing kernel setup as produced in the x y-approach developed in this paper.

5.2 Pure-rational multi-curve models

Unlike the preceding rational-LMM hybrid multi-curve models, we now consider rational
models for both, the discounting curve and the forecasting curve, that is for the ZCB price
y
process (PtxT )0≤t≤Ti and (Pt T )0≤t≤Ti , respectively, which feature as desirable properties (i)
i i

tractability, (ii) transparency of the dependence structure among the risk factors and thus
(iii) a good understanding of the resulting model for the spread dynamics between the
x- (discounting) and the y- (forecasting) curves. The rational price models considered by
Macrina [34], and by Crépey et al. [11] for multi-curve interest rate modelling in particular,
offer the set of properties we require. For the x- and y-ZCB, we postulate the following:
Qm y Qny
k=1 Zk (t, Ti ) `=1 Z` (t, Ti )
x x
P0T y
P0T
PtxT = =
i i
m , Pt T y Qn y , (5.10)
k=1 Zk (t) P0t `=1 Z` (t)
x x
Q
i
P0t i

y y y
where Zkx (t, Ti ) = (1 + bkx (Ti ) Axt, k ) and Z` (t, Ti ) = (1 + b` (Ti ) A t, ` ) are taken to be positive
x y
processes. The quantities P0t and P0T are the initial term structures of the x and y ZCBs,
i
y
bk and b` are deterministic functions, and (Axt, k ) and (A t, ` ) are martingales with respect
to some (P-equivalent) probability measure. For further (technical) details, we refer to
y
Macrina [34] and Crépey et al. [11]. We take a closer look at (Pt T ), although the structural
i

properties of the model also apply to (PtxT ). The return process of the forecasting ZCB is
i

given by
y y y
n 1 + b` (Ti ) A t, `
‚ Œ ‚ Œ
€
y
Š P0T X
= ln +
i
ln Pt T y ln y y . (5.11)
i
P0t `=1
1 + b` (t) A t, `

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 y
The associated short rate process (r t ) is given by

y n
∂ t P0t
‚ Œ
X
y y
rt =− y + θ t, ` , (5.12)
P0t `=1

y y
where we define the (A t, ` )-driven factor component (θ t, ` ) by

y y
y
∂ t b` (t) A t, `
θ t, ` = y y . (5.13)
1 + b` (t) A t, `

Now let us assume, for the sake of the explanation, that the number n of factor components is
given by the particular tenor y. So, let a = 1, 2, 3, . . ., y = 3a which is the 3-month, 6-month,
9-month, 12-month, etc LIBOR tenor, and n = a + 2 the number of factor components. For
the 1-month LIBOR tenor, we assume that the short rate of the associated 1-month ZCB is
driven by two factor components, i.e n = 2. Then, we have the following additive structure
for the short rate model associated with the corresponding forecasting ZCBs:

∂ t P0t
1
 
y = 1-month-tenored ZCB, (Pt1T ) : r t1 =− 1
+ θ11 (t) + θ21 (t) ,
i
P0t
∂ t P0t
3
 
y = 3-month-tenored ZCB, (Pt3T ) : r t3 =− 3
+ θ13 (t) + θ23 (t) + θ33 (t) ,
i
P0t
.. ..
. .
y a+2
∂ t P0t
‚ Œ
X
y y y
y = 3a-month-tenored ZCB, (Pt T ) : rt =− y + θ` (t) , a = 1, 2, 3, . . . .
i
P0t `=1
(5.14)

Depending on the specific interbank offer rate market, we could envisage the situation where
j
θ`i = θ` for all i, j = 3a. This would mean that the various y-curves only differed by the
number of factor components driving the corresponding short rates (i.e, forecasting ZCBs).
We would then have
y a+2
∂ t P0t
‚ Œ
X
y y
y-month-tenored ZCB, (Pt T ) : rt =− y + θ` (t) , a = 1, 2, 3, . . . , (5.15)
i
P0t `=1

where the short rate model of the 1m-tenored ZCB is recovered by setting a = 0. From the
FRA price process (3.21), one sees that the quantity responsible for the consistent transfer
xy
from a single-curve to a multi-curve setting is the quanto-bond with price process (Pt T ).
i

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 Next we introduce the multiplicative class of rational models for the “multi-curve” quanto-
xy
bond price process (Pt T )0≤t≤Ti :
i

y Qn y
`=1 Z` (t, Ti )
1 ” y — P0T
xy
= x E hT Ft =
i
Pt T Qm . (5.16)
k=1 Zk (t)
ht x x
i i
P0t

xy
The model for the short rate of interest (r t )0≤t , associated with the quanto-bond, is ob-
xy xy
tained by r t = −∂ Ti ln(Pt T )| T =t , assuming that the quanto-bond price function is differ-
i
xy y
entiable in its maturity Ti . It follows that r t = r t . One could argue that it is somewhat
artificial to introduce the x-discounting bond because, after all, the x-curve may be a specific
y-curve. We wish however to allow for more generality: there is no reason why the type
of model ought to be the same for the x-ZCB and for the y-ZCB. It is only for convenience
that we here decide to consider the same type of pricing model for both types of bonds. In
any case, the discounting curve—identified with the one-day deposit—can be viewed as the
y = 0-forecasting curve in the above setup (5.14):

∂ t P0t
0
 
1-day-tenored ZCB, PtxT = Pt0T : r tx = r t0 =− 0
+ θ10 (t) . (5.17)
i i
P0t

A byproduct of the multi-curve modelling approach based on bonds as considered in this

paper, is the implicit, or rather emerging, spread models. Within the rational models, the
process for the spread between the y and y + 3m curves is given by

y+3m y y+3m
y, y+3m
Pt T P0t P0T
= = ∆a+2 (t, Ti ), a = 1, 2, 3, . . . ,
i i
st T y y+3m y (5.18)
i
Pt T P0t P0T
i i

where the stochastic spread process (∆a+2 (t, Ti ))0≤t≤Ti is given by

y y
1 + ba+2 (Ti ) A t, a+2
∆a+2 (t, Ti ) = y y . (5.19)
1 + ba+2 (t) A t, a+2

We note that the stochastic spread is positive assuming that the rates underlying the tenors
are non-negative, see Corollary 3.2.

5.3 Linear-rational term structure models

Filipović et al. [15] introduce the so-called linear-rational term structure (LRTS) models. In
this section we show how the multi-curve extension to the LRTS is produced by showing that

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the LRTS models belong to the more general class introduced in the previous section. We
thus prove that (a) the LRTS models belong to the class of models developed in Macrina [34]
when an infinite-time horizon is considered, and (b) that the pricing kernel generating the
LRTS is a weighted heat kernel (WHK). Pricing kernels generated by WHKs in an infinite time
horizon setting are introduced in Akahori et al. [1] and developed in Akahori & Macrina [2]
in the case tha the WHK is driven by a time-inhomogeneous Markov process. In particular,
we shall show that the LRTS models produce bond price processes (Pt T )0≤t≤T of the form

P0T + b(T ) A t
Pt T = , (0 ≤ t ≤ T ) (5.20)
P0t + b(t) A t

which are identified as a class of Markov functionals. The function b(t), 0 ≤ t ≤ T , is

deterministic and (A t )0≤t is a martingale process. The explicit construction of this class of
term structure models is presented in Macrina [34].

Definition 5.1. Linear-Rational Term Structure Models, Filipović et al. [15].

Let (Z t )0≤t denote the multivariate process with state space E ⊂ Rm that satisfies the stochastic
differential equation
dZ t = κ(θ − Z t )dt + dM t , (5.21)

where κ ∈ Rm×m and θ ∈ Rm , and where (M t )0≤t is an m-dimensional martingale. Let (ζ t )0≤t
denote the pricing kernel process defined by

ζ t = e−αt (φ + ψZ t ) , (5.22)

where α ∈ R, φ ∈ R, and ψ ∈ Rm such that φ + ψz > 0 for all z ∈ E. The linear-rational

term structure, generated by the linear pricing kernel process (ζ t )0≤t , have zero-coupon bond
price processes (Pt T )0≤t≤T given by

φ + ψθ + ψe(T −t) (Z t − θ )
Pt T = e−α(T −t) , (5.23)
φ + ψZ t

where T is the bond maturity date.

Proposition 5.3. The stochastic differential equation (5.21) has the unique solution given by
 Z t 
−κt κs
Zt = e Z0 + κ e ds θ + e−κt A t . (5.24)
0

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The process (A t )0≤t , defined by
Z t
At = eκs dMs , (5.25)
0

is a martingale.

Proof. That the mean-reverting process (5.24) is the unique solution to the SDE (5.21)
follows from a straightforward application of Ito’s Lemma. To show that (A t )0≤t is a martin-
gale, one remarks that E[| A t |] < ∞ for all t ≥ 0 and that E[Au |Fs ] = As , for 0 ≤ s ≤ u. The
Ru
latter follows by calculating E[ s d[φ(t)M t ] | Fs ], where 0 ≤ s ≤ t ≤ u, and by applying
Fubini’s theorem. One then obtains
Z u 
E[Au |Fs ] − As = E[φ(u)Mu − φ(s)Ms | Fs ] − E M t ∂ t φ(t)dt Fs = 0, (5.26)
s

which completes the proof.

Theorem 5.1. The pricing kernel process (ζ t )0≤t that generates the linear-rational term struc-
ture models, specified in Definition 5.1, is given by

ζ t = ζ0 [P0t + b(t) A t ] , (5.27)

where ζ0 = φ+ψZ0 . The positive, deterministic function (P0t )0≤t≤T is the initial term structure
of the associated T -maturity bond system with price process

P0T + b(T ) A t
Pt T = (0 ≤ t ≤ T ) (5.28)
P0t + b(t) A t

where P0t , the deterministic function b(t) and the martingale (A t ) are determined by
Z t
e−αt
  
−κt κs
P0t = φ + ψe Z0 + κ e ds θ , 0 ≤ t ≤ T, (5.29)
φ + ψZ0 0
e−αt
b(t) = ψe−κt , 0 ≤ t ≤ T, (5.30)
φ + ψZ0
Z t
At = eκs dMs , t ≥ 0. (5.31)
0

Proof. One direction is straightforward: it suffices to insert (5.29), (5.30) and (5.31) in
(5.28) to obtain (5.23). The other direction, i.e. beginning from Definition 5.1, goes as

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follows: The solution (5.24) is inserted in (5.23) to obtain
” € Rt Š— Rt
e−αT φ + ψe−κT Z0 + κ 0 eκs ds θ + e−αT ψκ 0 e−κ(T −s) ds θ + e−αT ψe−κT A t
Pt T = ” € Rt Š— .
e−αt φ + ψe−κt Z0 + κ 0 eκs ds θ + e−αt ψe−κt A t
(5.32)
Next, we define the functions γ(t, T ), λ(t, T ) and b̃(t) by
  Z t 
−αT −κT κs
γ(t, T ) = e φ + ψe Z0 + κ e ds θ , (5.33)
0
Z t
−αT
λ(t, T ) = e ψκ e−κ(T −s) ds θ , (5.34)
0
b̃(t) = e−αt ψe −κt
(5.35)

for t ∈ [0, T ], and therewith express the bond price process in the form

γ(t, T ) + λ(t, T ) + b̃(T ) A t

Pt T = . (5.36)
γ(t, t) + b̃(t) A t

The initial term structure P0t , 0 ≤ t ≤ T , satisfies the relation γ(0, 0)P0t = γ(0, t)+λ(0, t) =
γ(t, t). Furthermore, γ(t, T ) + λ(t, T ) − [γ(0, T ) + λ(0, T )] = 0 holds. We thus write

γ(t, T ) + λ(t, T ) − [γ(0, T ) + λ(0, T )] + γ(0, 0)P0T + b̃(T ) A t

Pt T = , (5.37)
γ(0, 0)P0t + b̃(t) A t

and immediately obtain (5.28) by observing that b(t) = b̃(t)/γ(0, 0) for 0 ≤ t ≤ T .

Corollary 5.1. The Linear-Rational Term Structure models can be expressed in the form
 
P0T 1 + b̄(T ) A t
Pt T =  , (5.38)
P0t 1 + b̄(t) A t

for 0 ≤ t ≤ T , where b̄(t) = b(t)/P0t . This is the form (5.10) for m = 1, and thus the
necessary basis for the extension to the multi-curve linear-rational term structure models via
Theorem 3.1 and Definition 3.19, in a developed market, and via Definitions 3.2 and 3.3 in
the emerging market.

Proof. This follows directly from (5.28).

Remark 16. We emphasise that the form (5.28), or equivalently (5.38), shows that the Linear-
Rational Term Structure has, by (5.29), a functionally fully specified initial term structure P0t

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of bond prices for t ∈ [0, T ]. Also, the models (5.28) specified by (5.29)-(5.31) produce an
example of the larger class (5.20), or equivalently (5.38), of term structure models that can
accommodate unspanned stochastic volatility as considered in Filipović et al. [15], Section C.

Next we consider weighted heat kernel processes over an infinite-time horizon, see Aka-
hori et al. [1], and in particular the case where the propagator is a conditional expectation,
as in Akahori & Macrina [2] and Macrina [34]. Such weighted heat kernels are used to
generate (explicit) pricing kernel processes. The definition that follows provides weighted
heat kernels in a multivariate setting.

Definition 5.2. Let (X t )0≤t be an m-dimensional (F t )-adapted Markov process, F (t, x) be

a vector-valued and deterministic function in Rm , and w(t, u) a matrix-valued deterministic
function in Rm×m . Furthermore, let the functions f0 (t) ∈ R and f1 (t) ∈ Rm be deterministic.
The process (π t )0≤t is a weighted heat kernel defined by
Z ∞
π t = f0 (t) + f1 (t) w(t, u)E [F (t + u, X t+u ) | F t ] du, (5.39)
0

where t ∧ u ≥ 0, and f0 (t), f1 (t), F (t, x) and w(t, u) are chosen such that (π t ) is a positive
and finite (scalar-valued) process.

The next statement asserts that the pricing kernel process (ζ t ) in Filipović et al. [15] is
a weighted heat kernel and it establishes the relation between (ζ t ) and the class (5.39).

Theorem 5.2. The pricing kernel (5.22) that generates the linear-rational term structure mod-
els by Filipović et al. [15], is a special case of the process (5.39) where the following holds:

1. Let (X t ) be the Markov process (Z t ) that satisfies (5.21).

2. F (t, X t ) = Z t , for all t ≥ 0.

3. w(t, u) = e−β(t+u) , β ∈ Rm×m invertible where βκ = κβ for κ ∈ Rm×m invertible.

4. The functions f0 (t) and f1 (t) are give by

f1 (t) (β + κ)−1 − β −1 e−β t θ + e−αt φ,

 
f0 (t) = (5.40)
f1 (t) = e−αt ψeβ t (β + κ), (5.41)

where φ ∈ R, α ∈ R, θ ∈ Rm , ψ ∈ Rm and β ∈ Rm×m with βκ = κβ for κ ∈ Rm×m . It

is assumed that (β + κ) is invertible.

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Proof. One direction is straightforward: It suffices to insert items 1- 4 into Equation (5.39)
to obtain the pricing kernel process (5.22). In the other direction, that is starting from
(5.39), one makes the initial assumptions that the first and second items shall hold. This
leads to
 Z t+u  Z t
κs
−κ(t+u)
E [Z t+u ) | F t ] = e Z0 + κ −κ(t+u)
e ds θ + e eκs dMs . (5.42)
0 0

Then, by choosing the ansatz given in the third item, one obtains
Z ∞
w(t, u)E [F (t + u, X t+u ) | F t ] du = (β +κ)−1 e−β t Z t + β −1 − (β + κ)−1 e−β t θ . (5.43)
 
0

Thus, the functions f0 (t) and f1 (t) are selected such that the pricing kernel process (5.22)
is obtained, that is (5.40) and (5.41).

6 Inflation-linked and FX pricing

In this section, we show how the across-curve valuation approach developed in this paper
extends to the pricing of other fixed-income financial instruments. The curve-conversion
factor process, developed in the present work, may conveniently be applied to the pric-
ing and hedging of inflation-linked and foreign-exchange (FX) securities. In particular, the
xy
quanto-bond process (Pt T )0≤t≤T plays an important role in the pricing of hybrid securities,
suchlike inflation-linked foreign-exchange products, where consistent asset valuation can
still be a challenge.

6.1 Inflation-linked pricing

It is customary in inflation-linked price modelling and hedging to consider two economies,

the so-called nominal and real economies. Such a viewpoint matches the x y-concept so
much so that the curve-conversion factor associated with inflation-linked pricing is obtained
with little effort. But this is the strength and appeal we see in this formalism. The nominal
(N), cash-based economy is associated with the x-curve, and the real (R), goods/services-
based economy is associated with the y-curve. So, we set x = N and y = R. Next we apply
the scheme developed in Sections 2 and 3 of this paper.
We assume positive pricing kernel processes (hNt )0≤t and (hRt )0≤t for the nominal and the
real economies, respectively. The process (C t )0≤t of the consumer price index links prices

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between the nominal and the real economies by

hRt
C t = C0 , (6.1)
hNt

where C0 is the base price level at time 0 (not necessarily normalised to one). The price
PtNTR at time t ≤ T of an inflation-linked discount bond with cash flow C T at maturity T is
given by
1 N CT 1  R
• ˜ 
PtNTR = N
E h T | F t = N E hT | Ft . (6.2)
ht C0 ht
In the x y-formalism, where we recall x = N and y = R, we may write the price process
(PtNTR ) in terms of the conversion formula

PtNTR = PtNT Q Nt TR , (6.3)

where (PtNT ) is the price process of the nominal discount bond, and where
 
E hRT | F t
Q Nt TR =  N  (0 ≤ t ≤ T ) (6.4)
E hT | Ft

is the curve-conversion factor (spread process) linking discounting on the nominal N -curve
and forecasting on the real R-curve. The expression for the quanto-bond (6.2) can be ob-
tained in a straightforward fashion from Eq. (2.4) by setting t = T, thereafter replacing the
pricing time s with t, and further by setting x = N , y = R and H TR = 1. The nominal curve
serves as the base-curve; hence the curve-conversion factor process (6.4), in the relation
(6.3), quantifies the number of positions in the nominal T -maturity discount bond neces-
sary to replicate the no-arbitrage value at t ∈ [0, T ] of the inflation-linked discount bond
with value PtNTR at time t. Given that the nominal discount bond PtNT and the inflation-linked
discount bond PtNTR are traded sufficiently on a market, one can imply from the market the
inflation-linked conversion factor
PtNTR
Q Nt TR = . (6.5)
PtNT
The pricing formulae for an inflation-linked forward rate agreement (or inflation-linked
zero-coupon swap) and for a year-on-year swap contract can be expressed in terms of the
conversion factor. The derivations of such pricing formulae follow those for the forward
rate agreement and the swap contracts presented in Section 3. Price models for inflation-
linked securities, which are based on explicit pricing kernel models—hence, on explicit curve

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conversion factor processes—have been developed by Dam et al. [13]. Such models feature
a high degree of flexibility and good calibration properties.

6.2 Exchange to foreign currencies

We consider two currencies i and j in the respective nominal (cash-based) economies Ni

and N j . Here we show that the forward foreign exchange rate, which converts an amount
of domestic currency j into an amount of foreign currency i at a fixed future data, is given
by today’s spot exchange rate multiplied with the appropriate currency conversion factor.
We set x = i and y = j in the xy-formalism, see Sections 2 and 3. In the following, we
abbreviate “foreign exchange" with “FX".
ij
We denote by (X t )0≤t the spot FX rate process, which converts, e.g., GBP to EUR. We
ij
emphasise that the notation i j implies, in this example, EUR/GBP. By (F t T )0≤t≤T we denote
the process of the forward FX rate. We conjecture the following relation:

j
ij ij Pt T
Ft T = Xt . (6.6)
PtiT

j
Here, (PtiT )0≤t≤T and (Pt T )0≤t≤T are assumed to be the nominal OIS discount bond price
processes denominated in the i (EUR) and j (GBP) currencies, respectively. We acknowledge
that the correct discount bond price processes, in practice, are those determined by the
respective FX basis curves. While these may be easily incorporated into the framework
via pricing kernels and associated curve-conversion factor processes, we ignore this fact
ij ij
throughout this section for ease of exposition. We note that F t t = X t , t ∈ [0, T ]. The i-
and j-denominated economies are assumed to be equipped with the respective (nominal)
j
pricing kernel processes (hit ) and (h t ). By recalling the price formula of a discount bond, it
follows from the conjecture (6.6) that

j
ij ij hit E[h T | F t ] i
i j ht i j
Ft T = Xt j   = Xt j QtT , (6.7)
h t E hiT | F t ht

ij
where the FX conversion factor (Q t T ) for the currency pair (i, j) has the familiar form

j
ij E[h | F t ]
QtT =  Ti . (6.8)
E hT | Ft

Next we validate the conjecture (6.6) by pricing an FX forward contract in this setup.

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 ij
We model the spot FX rate process (X t ) by

j
ij ij ht
X t = X0 , (6.9)
hit

and, by recalling (6.7), we obtain

ij ij hit ij ij ij
Ft T = Xt j
QtT = X0 QtT . (6.10)
ht

This is the relation we would expect to emerge in the xy-approach for the forward FX process.
The stochastic price dynamics of the forward FX contract are determined by the ratio of the
forecasting curves in the two economies denominated in units of the respective currencies.
We shall now see whether the expression (6.10) for the forward FX rate is indeed the fair
rate obtained from pricing the FX forward contract.
j
Proposition 6.1. Let (PtiT )0≤t≤T and (Pt T )0≤t≤T be the price processes of the discount bonds
ij
denominated in the i and j currencies, respectively. Let (X t ) t≥0 be the spot FX rate process
exchanging j currency for i currency at time t ≥ 0. Then, for 0 ≤ t ≤ T , the fair forward FX
rate is given by
j
ij ij ij ij Pt T
Ft T = X 0 Q t T = X t , (6.11)
PtiT
ij
where (Q t T )0≤t≤T is the curve-conversion process (6.8).

Equation (6.11) confirms the expression given in conjecture (6.6). Furthermore, the
ij
FX curve-conversion factor process (Q t T )0≤t≤T can be implied from the quoted forward FX
rates and the spot rates on the market, that is,

ij
ij Ft T
QtT = ij
. (6.12)
X0

ij ij
Proof. Consider the payoff VTi = X T /X 0 − K i of an FX forward contract, with expiry date
T > 0 and strike value K i , denominated in i-currency. The price process (VtiT ) of the FX
forward contract is given by

1 ” €
ij ij
Š —
VtiT = E hiT X T /X 0 − K i F t . (6.13)
hit

This follows as an application of the across-curve formula (2.4), where one sets x = i and

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y = j, alongside t = T and where the pricing time s is replaced with t. Furthermore,
j ij ij
H T = 1 − K i /Q T T shall hold, which is indeed a j-currency quantity. The relation H t T = VtiT
is obtained where we drop the j superscript in VtiT to emphasise that the value VtiT at time
t ∈ [0, T ] is given in units of the i-currency. Then, by recalling Eq. (6.9), it follows with
ease that
ij
VtiT = Pt T − K i PtiT , (6.14)

for t ∈ [0, T ]. By setting VtiT = 0, for all t ∈ [0, T ], we obtain the result stated in the
ij ij ij
proposition, where K ti T = F t T /X 0 = Q t T is the fair (strike) value for the forward currency-
exchange process.

6.3 Multi-curve interest rate foreign-exchange hybrid

We consider the situation whereby an investor wishes to enter a foreign-currency forward

contract on LIBOR. An example might clarify this type of hybrid security. Suppose we con-
sider GBP-based LIBOR, as quoted in the U.K. market. An investor wishes to enter a USD-
denominated forward contract written on the GBP-based LIBOR quotes. This exposes the
investor to the risk underlying the GBP-LIBOR market and the currency-exchange risk be-
tween GBP & USD. We are interested in deducing the fair forward rate process of the USD-
forward contract based on GBP-LIBOR. This is obtained with ease in the xy-approach by
combining the results in Sec. 3.2, on multi-curve systems in developed markets, and in Sec.
6.2, above.

Proposition 6.2. Consider 0 ≤ t ≤ Ti−1 < Ti where Ti − Ti−1 is the tenor of the GBP-based
LIBOR and Ti is the expiry date of the USD-denominated forward contract that is written
x y
on the GBP-based LIBOR. The fair forward rate process K t $ £ (Ti−1 , Ti )0≤t≤Ti−1 of the USD-
denominated forward contract is given by

x y
F t$£
T x y x y
K t $ £ (Ti−1 , Ti ) = L t £ £ (Ti−1 , Ti ) = L t $ £ (Ti−1 , Ti ),
i
(6.15)
X 0$£

where X 0$£ is the spot USD/GBP exchange rate at t = 0, the fair forward USD/GBP exchange
rate process (F t$£
T )0≤t≤Ti is given by the relation (6.11) and the GBP-based LIBOR process
i
x y
L t £ £ (Ti−1 , Ti )0≤t≤Ti−1 is given by Eq. (3.13).

Proof. The starting point is the y-tenored GBP-based LIBOR, given in Lemma 3.1, which we

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convert, at time Ti−1 , into the x $ -market by the FX conversion factor (6.8). We obtain

x y x y x y£ y
L T$ £ (Ti−1 , Ti ) = Q$£
T L T£ £ (Ti−1 , Ti ) = Q T$ L £ (Ti−1 , Ti ), (6.16)
i−1 i−1 Ti i−1 i−1 Ti Ti−1

which is the USD-denominated GBP-based LIBOR. We note that the notation x £ and y£ stand
for GBP-OIS and GBP-y-tenor, respectively. As mentioned earlier, we ignore the GBP-USD FX
basis curve, for simplicity. However, this curve may be easily incorporated into the valuation
through an intermediate curve-conversion factor process for GBP-OIS to GBP-USD FX basis.
x y£
Next, we write the price Vt T$ at time t ≥ 0 of the USD-denominated forward contract
i

(written on the GBP-based LIBOR) that expires at Ti ≥ t. That is,

x y£ δi ” x
€ x y Š —
Vt T$ = X 0$£ x E h T$ L T$ £ (Ti−1 , Ti ) − K x $ | F t , (6.17)
i
ht $ i i−1

where K x $ is the strike rate of the contract. By Eq. (6.16) and the tower property of condi-
tional expectation, it then follows that
y
x y£ ht £ x y y
Vt T$ = x Pt T$ L t £ (Ti−1 , Ti ) − K x $ Pt T£ . (6.18)
i
ht $ i i

x y£
Setting Vt T$ = 0 for all t ∈ [0, Ti ] gives the result (6.15), where Eqs (2.3), (3.2), (3.13)
i

and (6.11) are used.

6.4 Inflation-linked foreign exchange hybrids

Given that the relations for prices of inflation-linked and FX securities are available in the
xy-approach, we can move on to the valuation of another hybrid financial instrument. We
consider the price process of a contract that gives exposure to inflation in the domestic
economy and is priced in a foreign currency. To answer this question, we take the example
of a forward bet on inflation/deflation in the j-economy valued in units of the i-currency.
This could be taking a bet at t ∈ [0, T ) on the growth in the value of the U. K. price index
ij j j
in EUR, X T C T /C0 , at the fixed future date T .
j ij
Proposition 6.3. Let (C t ) t≥0 be the j-economy price index process (6.1) and (X t ) t≥0 the spot
N ij j j
FX rate (6.9). Consider the random payoff VT i = X T C T /C0 − K Ni , where K Ni is the nominal
N
i-currency strike value, and T is the fixed expiry date. The price process (Vt Ti )0≤t≤T of the
N
inflation-linked FX forward with cash flow VT i is given by

N ij N Ni R j N
Vt Ti = X 0 Pt Ti Q t T − K Ni Pt Ti , (6.19)

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 N
where (Pt Ti ) is the price process of the nominal discount bond in the i-economy, and where the
Ni R j
conversion factor process (Q t T )0≤t≤T is defined by
” R —
j
Ni R j
E hT | Ft
QtT = ” N —. (6.20)
E hT i | Ft

Ni R j
The fair forward inflation-linked FX rate process (F t T )0≤t≤T is given by

Nj R j
Ni R j ij Pt T
Ft T = Ft T Nj
. (6.21)
Pt T

Proof. We begin with Proposition 2.1: Set x = Ni and y = R j alongside t = T , and thereafter
replace the pricing time s with t. This gives,

Ni R j 1 ”
N Ni R j R j
—
Ht T = N
E hT i Q T T H T | Ft . (6.22)
ht i

Rj ij Ni R j
For the real-economy random cash flow at time T > 0 we set H T = X 0 − K Ni /Q T T , which
N
is a quantity denominated in units of the j-real-economy. Now we calculate the price Vt Ti
Ni R j N
at time t ∈ [0, T ] of the hybrid contract. We write H t T = Vt Ti to emphasise that the value
N
Vt Ti at time t ∈ [0, T ] is given in nominal units of the economy with currency i. We have:

N 1 ” €
N ij j j
Š —
Vt Ti = N
E h T i X T C T /C0 − K Ni F t (6.23)
ht i
ij
X0 ” R —
N
= E h T | F t − Pt Ti K Ni ,
j
N
(6.24)
ht i

where Eqs (6.1) and (6.9) are used. This can be expressed in terms of the appropriate
Ni R j
conversion factor process (Q t T )0≤t≤T . That is,

N ij N Ni R j N
Vt Ti = X 0 Pt Ti Q t T − Pt Ti K Ni , (6.25)

where ” R —
j
Ni R j
E hT | Ft
QtT = ” N —. (6.26)
E hT i | Ft

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 N
Setting Vt Ti = 0, for all t ∈ [0, T ], we obtain the fair inflation-linked FX forward process:

Nj R j
Ni R j i j Ni R j ij Pt T
Ft T = X0 QtT = Ft T Nj
, (6.27)
Pt T

which concludes the proof.

In summary, Equation (6.21) states that the fair rate of an inflation-linked FX forward
ij Nj Nj R j
is given by F t T /Pt T units of the bond Pt T , which is linked to inflation in the (domestic)
ij Nj Nj R j
j-economy. In developed markets, the assets with price F t T , Pt T and Pt T , respectively,
are (mostly) liquidly traded. The relation (6.21) determines the consistent hedge for the
i-currency inflation-linked FX forward in terms of the j-economy FX forward, the inflation-
linked bond and the zero-coupon bond in the j-market. We thus have (i) the consistent
Ni R j ij Nj R j
curve-conversion formula Q t T = Q t T Q t T , linking inflation-indexed and FX securities, and
(ii) the equivalent consistent relation (6.21) between the inflation-indexed and FX forward
rates.

7 Conclusions

In this paper, a framework is developed that allows for the consistent pricing and hedging
of financial assets, which depend on a spread between the rates their values accrue and are
discounted at. Such a situation is manifest in fixed-income markets, in particular, where
the return of instruments may accrue at one benchmark rate, e.g. LIBOR, and is discounted
at another benchmark rate, e.g. the OIS rate. The paradigm for modelling the prices of
tenor-based fixed-income products is the so-called multi-curve term structure framework.
Although the approach we develop in this paper is applicable whenever spreads among
different curves (term structures) need to be modelled, we consider fixed-income as the
market within which we develop what we term consistent valuation across curves. We choose
the modelling paradigm of pricing kernels to construct the consistent price systems that
give rise to, and also rely on, the curve-conversion process that allows for no-arbitrage
price conversions from one curve to another, as e.g. required in multi-curve interest rate
modelling. This can be viewed as a kind of currency foreign-exchange analogy, and we draw
several parallels with this view while we develop the xy-approach.
After the introduction of the curve-dependent discounting systems, we produce the
curve-conversion factor process that links cash-flows associated with different curves and
hence gives rise to consistent prices of assets, which accrue value according to the fore-

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casting curve and are discounted according to the discounting curve. The dual nature of
the curve-conversion factor also allows for conversion of curves. The deduced across-curve
pricing formula gives rise to the consistent set of numeraire assets and associated (risk-
neutral) probability measures so as to avoid the introduction of arbitrage opportunities in
a multi-curve market—or a ‘spread market’—see Section 2. The curve-conversion mecha-
nism enables the introduction of tenor-based zero-coupon bonds without undermining the
no-arbitrage requirement.
An intriguing by-product of the across-curve pricing kernel approach we develop is that
it proposes consistent pricing relations for multi-curve systems in emerging markets where
a derivatives market on one of the benchmarks, say the OIS system, is absent and needs
to be estimated. For example, the liquidly traded tenor may be used to calibrate the pric-
ing kernel model underlying the zero-coupon bond price system associated with the liquid
tenor. Although a multi-curve interest rate system is available in emerging markets, it has
an idiosyncratic and proprietary nature. Given an estimation methodology, one can apply
the xy-approach as a standard to consistently price instruments in a multi-curve emerging
market. We show that the across-curve valuation method is applicable in developed (liquid)
markets as much as in emerging (less liquid) markets and that fixed-income products, such
as forward rate agreements, may be understood and priced with the same ease in both types
of markets.
Recently, interest in so-called rational models has grown and the advantages of using
this class of models to produce tractable interest-rate models, and extensions to the multi-
curve setting, have been recognised. We develop generic pricing kernel models for across-
curve valuation and show how rational multi-curve models, such as those of Crépey et al.
[11] and Nguyen & Seifried [44] are recovered within our xy-approach, and furthermore
the linear-rational term structure models by Filipović et al. [15] may be generalised to a
multi-curve environment. Moreover, important contributions have been made by several
authors to produce multi-curve extensions of the Heath-Jarrow-Morton framework. We try
to contribute to this research area by investigating the HJM-framework from the perspective
of our across-curve valuation scheme therewith suggesting multi-curve HJM-models.
Finally we show how inflation-linked, currency-based, and fixed-income hybrid securi-
ties can be priced by applying our consistent across-curve valuation method using pricing
kernels.

Acknowledgments. The authors are grateful to participants of the Avior Quantitative

Finance Research Seminar (Cape Town, March 2016), ACQuFRR & RMB Masterclass on

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“Catching up with Emerging Markets” (Johannesburg, July 2016), CFE 2016 (Sevilla, De-
cember 2016), STM2016 Workshop, Institute of Statistical Mathematics, Japan (Tokyo, July
2016), JAFEE 2016 (Tokyo, August 2016), and of the Seminar at the Graduate School of In-
ternational Corporate Strategy, Hitotsubashi University (Tokyo, March 2017) for comments
and suggestions. Moreover, questions, comments and suggestions by Henrik Dam, Martino
Grasselli, Matheus Grasselli and Erik Schlögl have been very much appreciated and have
led us to understand and develop our work on an across-curve valuation approach better
and further. The authors thank two anonymous reviewers with comments which helped
improve this paper.

A No-arbitrage strategy for conversion of cash flows and curves

Let us first consider a simple arbitrage relationship for an economy with default-free and
credit-risky interest rate curves, while assuming perfect market liquidity. Assume that the
x-curve is the default-free curve while the y-curve is one of a potential set of credit-risky
curves. Consider the following simple strategy, at time 0:

(i) Sell one unit of the numeraire asset in the x-market for 1/h0x ; and
y
(ii) Buy one unit of the numeraire asset in the y-market which costs 1/h0 ,
y
which costs zero to setup, i.e. Vt = 0, since h0x = h0 = 1. Transaction (i) is equivalent to
borrowing money via the x-market’s money market, while (ii) is equivalent to a deposit into
the y-market’s money market. Then at any time t > 0, the value of this strategy will be

1 1
Vt = y − ,
ht h tx

which will be greater than zero if the risky entity that holds the investment has not defaulted
by that time. Therefore, this strategy does not allow for arbitrage, in general. Now, let us
assume that one is able to mitigate all of the default-risk associated with the entity offering
the y-market investment via appropriate collateralisation. In such a circumstance, the value
of the strategy at any time t > 0 must equal zero, if we are to preclude arbitrage, otherwise
one would be ensured of earning a cash flow equal to Vt which would be greater than zero
with certainty at any time t > 0. No arbitrage may be achieved by adjusting the y-market
y
deposit by the ratio h t /h tx . At any time t > 0, this ratio is merely the realised multiplicative
spread between the discount factors realised in the x- and y-markets respectively.

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 y
Remark 17. In currency modelling, the ratio h t /h tx models the spot exchange rate between the
y
x- and y-currencies. In particular, 1 unit of y-currency may be exchanged for h t /h tx units of
x-currency at time t.

Another relevant arbitrage relationship to consider involves a finite horizon loan and in-
vestment strategy. Maintaining the same assumptions as before, consider the same strategy
as before at time 0, and then do the following at some time t ∈ (0, T ):

(i) Sell 1/h tx units of the x-market T -maturity bond for PtxT ; and
y y
(ii) Buy 1/h t units of the y-market T -maturity bond for Pt T ,

which again costs zero to setup at time 0, as before, and terminates at time t when the
money market loan and deposit is transferred to fixed horizon alternatives. Now, at any
time s ∈ [0, t), the same arguments apply as before while at time t the value of this strategy
will be
1 1
Vt = y y − ,
h t Pt T h tx PtxT

which again does not permit an arbitrage opportunity, due to the credit risk associated with
the investment leg of the strategy. If we again invoke collateralisation of the investment
leg of the strategy, then arbitrage is precluded at: (a) all times s ∈ [0, t) by adjusting the
y
y-market deposit by the ratio h t /h tx ; and (b) at time t by adjusting the y-market fixed term
y y
deposit by the ratio h t Pt T /h tx PtxT . If these adjustments are not enforced post collateralisa-
tion, then one would be ensured of a risk-free profit equal to Vt for all times t ∈ (0, T ].
y y
Remark 18. In currency modelling, the ratio h t Pt T /h tx PtxT models the forward exchange rate
between the x- and y-currencies. In particular, one can agree at time t to exchange 1 unit of
y y
y-currency for h t Pt T /h tx PtxT units of x-currency at time T ≥ t.

B Consistent changes of numeraire and measure

Here we discuss changes-of-measure, numeraire assets, martingales and therefore no-arbitrage

within the xy-formalism. The curve-conversion factor process (2.3) induces the changes-
of-measure between all introduced y-markets (or y-curves). In particular, it governs no-
arbitrage across all distinct markets associated with the economy under consideration. To
demonstrate this, we consider Proposition 2.1, along with an asset with a spot-defined fu-
y
ture cash flow H T and deduce that the value of such an asset in the x-market is

xy 1  y y 
Ht T = x E hT H T | Ft , (B.1)
ht

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for t ∈ [0, T ]. For each of the markets z = x, y, we introduce a change-of-measure den-
sity martingale (mzt )0≤t≤T which changes measure from the real-world measure P to the
equivalent (risk-neutral) measure Qz , along with the z-discount factor (Dtz ) such that 1/Dtz
is the natural numeraire under Qz . This also means that the z-market’s pricing kernel may
xy
be written as hzt = Dtz mzt . The price process (H t T )0≤t≤T can now be expressed, equivalently,
in terms of (a) the Q x risk-neutral measure and (b) the Q y risk-neutral measure:

y
xy 1 Qx  x x y y  mt 1  y y  xy y
Ht T = xE DT Q T T H T | F t = x x EQ y DT H T | F t = Q t t H t , (B.2)
Dt m t Dt

xy y y
where we emphasise that (Dtx H t T )0≤t≤T and (Dt H t )0≤t≤T are Q x - and Q y -martingales
respectively, by construction. Moreover, we may change measure from Qz to the T -forward
measure QzT via the Radon-Nikodym derivative

dQzT DTz PTz T

= , (B.3)
dQz Dtz PtzT

which acts on F T given information F t up to time t, and therefore we may now express
xy
the price process (H t T )0≤t≤T equivalently, in terms of (a) the x-market T -forward measure
and (b) the y-market T -forward measure:
y y y y
xy T  xy y  m t Dt Pt T QT  y  x y Q Ty  y  x y Ht
H t T = PtxT EQ x Q T T H T | F t = E y H |F
T t = P x
Q
tT tT E H T | F t = P x
tT tT y ,
Q
m tx Dtx Pt T
(B.4)
xy y y
where (H t T /PtxT )0≤t≤T and (H t /Pt T )0≤t≤T are Q Tx - and Q Ty -martingales respectively. Equa-
tions (B.2) and (B.4) clearly demonstrate the role of the curve-conversion factor process in
changing measure within and across markets. Furthermore, the price process’ martingale
property is preserved across markets (and curves), with the curve-conversion factor pro-
cess again enabling this property. The xy-approach precludes arbitrage within and across
different markets (and curves).

C Bootstrapping of initial term structures

C.1 Emerging markets

In an emerging market, one would have the following initial data: (a) the y-tenored spot
y yy yy yy
IBOR L0 (0, T1 ); (b) a set of fair FRA rates {K0 (T1 , T2 ), K0 (T2 , T3 ), . . . , K0 (Tn−1 , Tn )}; and
yy yy yy
(c) a set of fair IRS rates {S0 (0, Tn+1 ), S0 (0, Tn+2 ), . . . , S0 (0, Tn+m )}. Using this data, one

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may construct the initial y-ZCB system by the relations

y 1
P0T = y ,
1
1 + L0 (0, T1 )δ1
y
y
P0T
=
i−1
P0T yy ,
i
1 + K0 (Ti−1 , Ti )δi
yy Pn+ j−1 y
y
1 − S0 (0, Tn+ j ) k=1 δk P0T
=
k
P0T yy , (C.1)
n+ j
1 + δn+ j S0 (0, Tn+ j )

for i ∈ {2, 3, . . . , n} and j ∈ {1, 2, . . . , m}. In general, one will have to make use of a suitable
numerical bootstrapping technique to extend the y-ZCB system from the longest FRA matu-
rity to the set of IRS maturities. These results are all consistent with a classical single-curve
interest rate framework.

C.2 Developed markets

In a developed market, one would have the following initial data: (a) the y-tenored spot
xy xy xy xy
IBOR L0 (0, T1 ); (b) a set of fair FRA rates {K0 (T1 , T2 ), K0 (T2 , T3 ), . . . , K0 (Tn−1 , Tn )};
xy xy xy
and (c) a set of fair IRS rates {S0 (0, Tn+1 ), S0 (0, Tn+2 ), . . . , S0 (0, Tn+m )}. Using this data,
one may construct the initial y-ZCB system by the relations

y xy
P0T x
= 1 − δi P0T L0 (0, T1 ),
1 1
y y xy
P0T = P0T x
− δi P0T K0 (Ti−1 , Ti ),
i i−1 i
n+ j
X
y xy
P0T = 1 − S0 (0, Tn+ j ) x
δk P0T , (C.2)
n+ j k
k=1

for i ∈ {2, 3, . . . , n} and j ∈ {1, 2, . . . , m}. In general, one will have to make use of a suitable
numerical bootstrapping technique to extend the y-ZCB system from the longest FRA ma-
xy y y
turity to the set of IRS maturities. Interestingly, but not surprisingly, since Pst = (hs /hsx )Pst
for 0 ≤ s ≤ t, it follows that
‚ y Œ ‚ xy Œ
y 1 Pt T 1 Pt T
L t (Ti−1 , Ti ) = −1 =
i−1 i−1
y xy −1 , (C.3)
δi Pt T δi Pt T
i i

xy y
and therefore P0t = P0t for t ≥ 0.

Remark 19. Market practitioners may choose to construct a market-implied y-ZCB system,

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 y
which we will denote by {P0t } t≥0 , as follows

y 1
P0T = xy ,
1
1 + L0 (0, T1 )δ1
y
y
P0T
=
i−1
P0T xy ,
i
1 + L0 (Ti−1 , Ti )δi
Pn+ j−1 xy y
y
1 − k=1 δk S0 (0, Tn+ j )P0T
=
k
P0T xy , (C.4)
n+ j
1 + δn+ j S0 (0, Tn+ j )

for i ∈ {2, 3, . . . , n} and j ∈ {1, 2, . . . , m}, using the same initial data, available in a developed
market, as before. This is indeed what is currently done in practice, with no attention paid to
the fact that assumption (3.29) confounds the true forward IBOR process with a martingale
adjustment. Put differently, the resultant y-ZCB system is dependent on the x-ZCB system via
xy
the conversion factor Q ·· .

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