Two Curves, One Price

The financial crisis has multiplied the yield curves used to price plain vanilla interest rate derivatives, making classic single-curve no-arbitrage relations and pricing formulas no longer valid. Marco Bianchetti shows that no-arbitrage can be recovered by taking into account the basis adjustment bootstrapped from market basis swaps, and that generalised no-arbitrage double-curve pricing formulas can be derived for vanillas by using the foreign currency analogy, including a quanto-like adjustment typical of cross-currency derivatives. Both the basis and the quanto adjustments find a simple financial interpretation in terms of counterparty risk.