Interest rate swaps: a comparison of compounded daily versus discrete reference rates

Robert Jarrow () and Siguang Li ()
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Siguang Li: Hong Kong University of Science and Technology

Review of Derivatives Research, 2023, vol. 26, issue 1, No 1, 21 pages

Abstract: Abstract This paper studies the hedging effectiveness of interest rate swaps using different reference rates for eliminating interest rate risk from floating rate loans. Two reference rates are studied. The first rate’s maturity, $$\Delta$$ Δ , matches the payment interval of floating rate loans. The second has an incompatible maturity $$\Delta /N$$ Δ / N . The prime examples are LIBOR and SOFR, respectively. We show that the $$\Delta$$ Δ -based swap provides a good static hedge, but the $$\Delta /N$$ Δ / N -based swap does not. Although dynamic hedging with the $$\Delta /N$$ Δ / N -based swap is possible under some conditions, it both introduces model risk and increases transaction costs, making it a less practical alternative.

Keywords: Interest rate swaps; LIBOR; SOFR; Floating rate loans; E43; G12; G13; G21 (search for similar items in EconPapers)
Date: 2023
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DOI: 10.1007/s11147-022-09191-1

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