A Consistent Framework for Modelling Basis Spreads in Tenor Swaps

Yang Chang and Erik Schlogl
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Yang Chang: Finance Discipline Group, UTS Business School, University of Technology Sydney, http://www.uts.edu.au/about/uts-business-school/finance

No 348, Research Paper Series from Quantitative Finance Research Centre, University of Technology, Sydney

Abstract: The phenomenon of the frequency basis (i.e. a spread applied to one leg of a swap to exchange one oating interest rate for another of a different tenor in the same currency) contradicts textbook no-arbitrage conditions and has become an important feature of interest rate markets since the beginning of the Global Financial Crisis (GFC) in 2008. Empirically, the basis spread cannot be explained by transaction costs alone, and therefore must be due to a new perception by the market of risks involved in the execution of textbook "arbitrage" strategies. This has led practitioners to adopt a pragmatic "multi-curve" approach to interest rate modelling, which leads to a proliferation of term structures, one for each tenor. 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. The model parameters are calibrated to quoted market data on basis spreads, and the improving stability of the calibration suggests that the basis swap market has matured since the turmoil of the GFC.

Keywords: tenor swap; basis; frequency basis; liquidity risk; swap market (search for similar items in EconPapers)
JEL-codes: C6 C63 G1 G13 (search for similar items in EconPapers)
Pages: 54 pages
Date: 2014-05-01
New Economics Papers: this item is included in nep-mst and nep-ore
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Citations: View citations in EconPapers (5)

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