The Zeeman Effect in Finance: Libor Spectroscopy and Basis Risk Management

Marco Bianchetti

MPRA Paper from University Library of Munich, Germany

Abstract: Once upon a time there was a classical financial world in which all the Libors were equal. Standard textbooks taught that simple relations held, such that, for example, a 6 months Libor Deposit was replicable with a 3 months Libor Deposits plus a 3x6 months Forward Rate Agreement (FRA), and that Libor was a good proxy of the risk free rate required as basic building block of no-arbitrage pricing theory. Nowadays, in the modern financial world after the credit crunch, some Libors are more equal than others, depending on their rate tenor, and classical formulas are history. Banks are not anymore “too big to fail”, Libors are fixed by panels of risky banks, and they are risky rates themselves. These simple empirical facts carry very important consequences in derivative’s trading and risk management, such as, for example, basis risk, collateralization and regulatory pressure in favour of Central Counterparties. Something that should be carefully considered by anyone managing even a single plain vanilla Swap. In this qualitative note we review the problem trying to shed some light on this modern animal farm, recurring to an analogy with quantum physics, the Zeeman effect.

Keywords: crisis; liquidity; credit; counterparty; risk; fixed income; Libor; Euribor; Eonia; yield curve; forward curve; discount curve; single curve; multiple curve; collateral; CSA-discounting; liquidity; funding; no arbitrage; pricing; interest rate derivatives; Deposit; FRA; Swap; OIS; Basis Swap; Zeeman; Lorentz; quantum mechanics; atomic physics (search for similar items in EconPapers)
JEL-codes: E43 G12 G13 (search for similar items in EconPapers)
Date: 2011-10-31, Revised 2012-10-27
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Related works:
Working Paper: The Zeeman Effect in Finance: Libor Spectroscopy and Basis Risk Management (2012)
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