A consistent stochastic model of the term structure of interest rates for multiple tenors

Mesias Alfeus, Martino Grasselli and Erik Schlogl

Journal of Economic Dynamics and Control, 2020, vol. 114, issue C

Abstract: Starting from the observation that single-currency swap basis spreads contradict classical arbitrage arguments, we construct a framework where this basis arises due to the presence of “roll-over risk.” This risk consists of two components: (1) facing a higher credit spread (e.g. due to a credit downgrade) when rolling over short-term borrowing (2) heightened borrowing costs due to an absence of market liquidity. The model simultaneously fits OIS, interest rate swap and basis swap market quotes. Including CDS market quotes allows the two components of roll-over risk to be explicitly separated. This is highly relevant to the current LIBOR transition, illustrating why alternative benchmarks are fundamentally different from the rates they may be replacing.

Keywords: Tenor swap; Basis; Frequency basis; Liquidity risk; Swap market; LIBOR/OIS spread (search for similar items in EconPapers)
JEL-codes: C6 C63 G1 G13 (search for similar items in EconPapers)
Date: 2020
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (6)

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Related works:
Working Paper: A Consistent Stochastic Model of the Term Structure of Interest Rates for Multiple Tenors (2018)
Working Paper: A Consistent Stochastic Model of the Term Structure of Interest Rates for Multiple Tenors (2017)
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Persistent link: https://EconPapers.repec.org/RePEc:eee:dyncon:v:114:y:2020:i:c:s0165188920300312

DOI: 10.1016/j.jedc.2020.103861

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