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A Consistent Framework for Modelling Basis Spreads in Tenor Swaps

Researcher examining data

Yang Chang and Erik Schlogl

We take a more fundamental approach and explicitly model liquidity risk as the driver of basis spreads, reducing the dimensionality of the market for the frequency basis from observed spread term structures for every frequency pair down to term structures of two factors characterising liquidity risk. To this end, we use an intensity model to describe the arrival time of (possibly stochastic) liquidity shocks with a Cox Process.

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