Continuous tenor extension of affine LIBOR models with multiple curves and applications to XVA

TL;DR

This paper extends affine LIBOR models with multiple curves from discrete to continuous tenor using an interpolating function, enabling arbitrage-free modeling, initial curve fitting, and consistent XVA computation.

Contribution

It introduces a continuous tenor extension of affine LIBOR models that retains analytical tractability and arbitrage-freeness, facilitating accurate XVA calculations.

Findings

The extended model fits any initial forward curve.

The model remains arbitrage-free under the spot martingale measure.

Application to basis swap pricing and XVA analysis.

Abstract

We consider the class of affine LIBOR models with multiple curves, which is an analytically tractable class of discrete tenor models that easily accommodates positive or negative interest rates and positive spreads. By introducing an interpolating function, we extend the affine LIBOR models to a continuous tenor and derive expressions for the instantaneous forward rate and the short rate. We show that the continuous tenor model is arbitrage-free, that the analytical tractability is retained under the spot martingale measure, and that under mild conditions an interpolating function can be found such that the extended model fits any initial forward curve. This allows us to compute value adjustments (i.e. XVAs) consistently, by solving the corresponding `pre-default' BSDE. As an application, we compute the price and value adjustments for a basis swap, and study the model risk associated to different interpolating functions.