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**Interest Rate Derivative Pricing when Banks are Risky and Markets are Illiquid
**

Geoffrey R. Harris 1 and Tao L. Wu Stuart School of Business, Illinois Institute of Technology Third and Current Draft: May 17, 2011

Abstract: We examine the relative values of interest rate derivative contracts and cash LIBOR, particularly during the credit crisis from 2007 until present. There are substantial deviations from the results predicted by standard arbitrage pricing theory. We analyze the historical behavior of these deviations and their relationship to market measures of credit risk and liquidity. We introduce four different stochastic models of credit risk and liquidity, which make specific predictions of how these pricing deviations depend on the maturity of the contracts and the tenor of the underlying LIBOR rates. We then compare these predictions to empirical observations of the relative values of different forward rate agreements. JEL Classification: G12, G13, G01. Keywords: Interest Rate Derivatives, Interbank Markets, Eurodollar Futures, Forward Rate Agreements, Credit Risk, Liquidity Risk, Credit Crisis, Financial Crises.

Corresponding Author. Department of Finance, Stuart School of Business, Illinois Institute of Technology. 565 W. Adams St., Chicago, IL 60661. Tel. (312)-906-6533. Email: gharris@stuart.iit.edu. This research was supported by funds from the Stuart School of Business, Illinois Institute of Technology. We would like to acknowledge fruitful and helpful correspondence and discussions with Tom Bielecki, John Bilson, John Dean, Jonathan Harris, Tom Jacobs, Andrew Johnson and Xuan Zhou.

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1. Introduction: Underlying the standard methods of pricing derivative contracts is the assumption that market participants can borrow and lend in unlimited amounts at the risk-free rate. The most frequently traded interest rate derivatives have payoffs that depend on the inter-bank borrowing rate (LIBOR). Traditionally, the pricing and risk management of these interest rate derivatives have assumed that this rate is ‘risk-free’. Since the advent of the financial crisis that began in 2007, these assumptions have been violated to a considerable degree. In this work, we explore the implications of this for the relative valuation of simple interest-rate derivative contracts that depend on interbank lending rates. This paper is organized as follows. We begin by providing more detail about the theoretical context of this study and its relationship to previous literature. Next, we present intuitive arguments that illustrate how credit risk and illiquidity leads to the breakdown of basic relationships among different forward rates. We document that these relationships held until the start of the credit crisis in August 2007, but were then subsequently violated, leading to relative mispricings of interest rate derivative contracts. We shall refer to these mispricings as ‘anomalies’. We perform an empirical regression analysis, illustrating how these anomalies depend on market variables. To assess whether bid-ask spreads can explain the size of the mispricings, we examine market data for interbank loans traded on an exchange. We then introduce more formal models of credit and liquidity risk that can explain these mispricings, and show how these models imply differences in the behavior of the term structure of these pricing anomalies. Derivative agreements are priced by appealing to arguments based on the absence of arbitrage. Assume that two parties engage in a derivative transaction, i.e. a contract that depends on the value of an underlying asset, such as a stock or bond. Both parties can then hedge the impact of this derivative through a strategy that entails buying or selling other derivatives or the underlying asset. If the hedge is perfect, the market risk incurred by taking on the derivative position is eliminated. The hedged portfolio, by absence of arbitrage, should have a return equal to the risk-free rate. This constraint enforces a relationship between the values of the derivative and the instruments that are used as a hedge. The parties must borrow or lend money to establish the hedge position. The price of the derivative then depends on the borrowing and lending rates, the price of the underlying asset, and the parameters that determine the hedging strategy (e.g. the volatility of the asset). Until recently, it has been nearly universal practice, when pricing derivatives, to determine borrowing and lending rates from yield curves based on LIBOR (London Interbank Offer Rate) for a given currency and from the prices of derivative contracts based on these LIBORs, namely Eurodollar Futures contracts and interest rate swaps. On each business day, at 11 a.m. London time, the British Bankers Association (BBA) polls a set of banks, asking them to provide their best estimate of the rates which they would pay to borrow an amount of substantial size from other peer banks for terms of 1 day, 1 week, 2 weeks, one month, two months, and monthly up to one year. The USD LIBOR panel consists of sixteen banks. The LIBOR rate for each term is then computed by discarding the highest and lowest quartile of these quotes and averaging the remaining quotes.

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The interest rate used in derivative pricing is often referred to as the ‘risk-free’ rate. In the traditional arbitrage arguments used to price derivatives, it is implicitly assumed that no default will occur in the transactions carried out as part of the hedging strategy. If a default were to occur, the hedge could incur substantial credit losses, and its proceeds would not provide a perfect hedge for the derivative payoff. Furthermore, the hedging strategy assumes that the hedger not only can finance at the LIBOR rate today, but will be able to finance at this rate in the future. This might not be the case if their credit quality were to deteriorate significantly. When the credit quality of major financial institutions is strong, LIBOR is at least quite close to the risk-free rate, and the risk of default on a LIBOR-based loan is very small. A substantial portion of the institutions that transact large volumes of derivatives, such as J.P. Morgan and Citigroup, can indeed finance at these rates, and it is therefore reasonable to use LIBOR as the rate used in arbitrage arguments. When the risk of default of these institutions is small, the assumption that LIBOR is risk-free should not lead to substantial mispricing of derivatives. From August 2007 on through 2009, however, banks were under severe financial distress, and their perceived risk of default was significant. During a financial crisis such as this, lending at LIBOR, in carrying out a trading strategy, does expose an arbitrageur to significant credit risk. Furthermore, there is considerable uncertainty that financial institutions that could borrow at LIBOR would be able to continue to do so in the future. Hedging arguments used to derive arbitrage arguments will break down if the interbank lending market becomes highly illiquid, when it is difficult and to execute or unwind hedges, or if doing so entails large transaction costs. Lack of liquidity may also constrain the amount that an institution can borrow on the interbank market. This violates the assumption of the availability of unlimited borrowing implicit in arbitrage arguments. It is difficult to disentangle the effects of illiquidity and credit risk. This is, in part, because the two factors are strongly correlated. Market illiquidity spikes up when perceptions of credit risk increase; securities issued by more credit risky entities tend to be less liquid. There is a significant body of research that addresses the relevant impact of credit risk and liquidity on bonds and default swaps; see Lesmond, Chen and Wei (2005), Longstaff, Mithal and Neis (2005) and Ericsson and Renault (2006). Most of these studies conclude that the yield premium for illiquidity is significant, and of the same order of magnitude as the premium for credit risk. Recent work by Schwarz (2009) has also demonstrated large differences in yields between instruments with essentially identical credit risk, but differences in liquidity. It therefore seems plausible that these anomalies can only be fully explained with models of both credit and liquidity risk. Note, however, that the standard models used to price and hedge credit risky instruments are developed by characterizing the impact of losses due to default and not explicitly modeling liquidity risk. They may be adequate for pricing and risk management, if the impact of credit and liquidity risk is approximately of the same form. In this case, the impact of liquidity together with default risk would simply be reflected by the values of the model parameters, which are typically obtained via calibration to market prices. In this paper, although we study anomalies that violate standard arbitrage pricing arguments for interest rate derivatives, we still work within the framework of arbitrage pricing theory. This is valid if the additional sources of credit and liquidity risk can be hedged; i.e. if markets are complete. Such hedging could be carried out with credit derivatives and basis swaps, though it is not guaranteed that these will in practice succeed as effective hedges for the credit

during which markets in basis swaps and default swaps were liquid. often known as CVA. . 4 3 When netting is legally enforced (as is usually the case). The impact of collateralization on derivatives pricing has been explored by Johannes and Sundaresan (2003). These anomalies are largely a consequence of the breakdown of arbitrage arguments connecting the interbank lending and derivatives market. Canabarro (2010) and Morini and Prampolini (2010). which has been approached in many different ways in the literature.3 Billion and in 2009 this was 1. For OTC contracts. we shall argue that it has a minimal role in explaining the anomalies in interest rate derivatives that are the focus of this paper. many of which are reviewed by Staum (2007). an acronym for credit valuation adjustment. which stipulate that. This is because the different agreements may have offsetting values. arbitrage pricing models might not work well. The bulk of over-the-counter derivative transactions are collateralized. due 2 Bergman (1995) works out bounds for prices of equity options. such as Eurodollar futures. They can have a significant value for over-thecounter (OTC) derivatives. Much of the analysis in this paper is based on market data from 2009 and early 2010. however. see Duffie and Huang (1999). These adjustments. so that the assumption of market completeness seems a plausible approximation. the value of all derivatives between a pair of counterparties is aggregated 4. Cialenco and Iyigunler (2011) has been made in modeling the dependence of derivative prices on funding rates and the structure of collateralization agreements. particularly during the last few years. Fujii and Takahashi (2010) and Bielecki (2011) and Bielecki. Although counterparty credit risk and collateralization are of considerable significance in the pricing of derivative securities. such as swaps 3. In this case. Particularly in a crisis period with high illiquidity. This analysis can be extended to interest rate derivatives. are quite wide. JP Morgan Chase reports the mark-to-market change of their CVA annually. they may be less liquid and the assumption of market completeness might be strongly violated. par swaps and forward rate agreements struck at the current forward rate). and is quite simple for swaps and FRAs. The aggregate amount of derivatives transacted by large banks is so large that the total CVA is considerable.9 Billion (see the J. One is confronted with a complex incomplete markets problem. Burgard and Kjaer (2010). This is primarily because the anomalies we discuss depend on relatively short maturity instruments which are struck with initial value zero (e. For instance. significant progress by Piterbarg (2010). Pykhtin (2005). in 2008. are essentially nil for derivatives traded on exchanges. Morgan Chase Annual Report (2009)). for purposes of determining obligations in the event of counterparty bankruptcy. P. the effectiveness of these hedges may be reduced. These approaches often lead to bounds rather than exact prices 2. this was -2. the aggregate CVA for a set of contracts is typically much smaller than the sum of the CVAs computed if each agreement were considered to be in isolation. this significantly reduces the impact of counterparty credit risk on pricing. The resulting bounds.4 and liquidity risk factors that affect the valuation of interest rate derivatives.g. More recently. The analysis of this paper complements the work referenced above on derivative counterparty risk. one borrows and lends at different rates. given that in hedging. Financial institutions compute adjustments to the prices of their derivative contracts due to the possibility that the counterparties in these contracts may default. the size of these adjustments is reduced considerably through netting agreements.

for instance. Differences in pricing between rates inferred from related cash and derivative contracts. In this section. From the yield curves that are constructed. as the maturities of our contracts are short. For instance. at time S rather than S + T.S. the non-linearity in the dependence of Eurodollar futures contracts on the price of the underlying debt. S+T)T at time S+T 5. which is studied in the remainder of the paper. One consequence of the pricing anomalies that we observe is that this procedure no longer works well. and the differences in timing of cash flows between futures and forward contracts are the source of ‘convexity corrections’ in the difference between futures and forwards rates.g. This is of relevance to derivatives with payoffs that depend on LIBOR. so that. Their empirical observations of the futures-forwards basis. in this case. These convexity corrections depend on the volatility of interest rates. the forward value of 6-month LIBOR can be inferred from these yield curves. The rates that underlie Eurodollar futures (and many swaps) are 3-month LIBOR. we find the opposite sign in the futures-forwards basis. Gupta and Subrahmanyam (2000) and Chance (2006). we present intuitive arguments that illustrate how credit and liquidity effects lead to modifications of the traditional arbitrage arguments. so that the convexity correction is negligible. 2. The standard practice in building yield curves based on LIBOR is to infer LIBOR yields from the prices of Eurodollar futures and swaps. In later sections of this paper. The standard relationship between forwards of different maturities can be derived by imposing absence of arbitrage on a forward agreement plus its hedge. 5 This agreement is not quite identical to a standard Forward Rate Agreement (FRA). an identity that is used frequently in fixed income calculations and particularly when bootstrapping yield curves. we will introduce formal models that explain this behavior. in their study. one cannot exactly price derivatives based on 6-month LIBOR using standard yield curve construction techniques applied to 3-month LIBOR rates. one then infers forward rates. most interest rate derivatives. The Anomalies and their Consequences We now explain how credit and liquidity effects lead to the failure of the ‘composition’ relationship. and have a strong increasing dependence on contract maturity. did provide evidence of the presence of convexity corrections. In fact. can also be explained by slight differences in the payoffs of these contracts. This work also extends a strand of literature that addressed the relative pricing of cash LIBOR rates and Eurodollar/Euribor futures and of swaps and Eurodollar futures. e. in exchange for receiving a floating rate payment equal to f(S. i.e. which requires it to pay a fixed payment R(t. however. . such as cash LIBOR rates and Eurodollar/Euribor futures. which constitute a large portion of the over-the-counter derivatives market. These forward rates may span maturities other than 3 months.S+T)T at time S+T. the effect of credit risk would have led to relative pricing of the sign opposite to that observed in the data.5 to the uncertainty of whether an institution that can currently fund at LIBOR will be able to do so in the future. Grinblatt and Jegadeesh (1995) argued that credit risk did not explain the relative pricing of Eurodollar futures and cash forward rates. Grinblatt and Jegadeesh (1995). In our analysis.S. and because our analysis is performed over a period in which credit and liquidity risk are elevated. Consider a bank that enters into a forward agreement at time t. and one can then price instruments that depend on 6-month LIBOR. see Sundaresan (1991). The interest payments in a standard FRA are discounted and exchanged in arrears.

S+T) satisfies (1) (1 + dS − dt d − dS d − dt f (t . In this paper.t.S. If the amount that they need to borrow is extremely high. S ))(1 + S +T f (t . this is because credit risk is mean-reverting and credit quality has a tendency to revert to a mean level which is worse than that of a typical LIBOR-paying bank. S + T )). S . this may not be the case. it is more likely that their credit quality will deteriorate than improve. the bank should have to pay a forward rate lower than the rate computed via the idealized arbitrage argument. 360 360 360 In previous literature. S+T). It follows that f(t. In the recent crisis. or their marginal borrowing rates may be so . S ))(1 + S +T f (t . By absence of arbitrage. t . Underlying the arbitrage argument is the assumption that financial institutions can borrow unlimited amounts at their funding rate. With limited market liquidity. The value of this forward agreement changes as interest rates move.S. S.S+T) for which the forward agreement has value zero at time t is (by definition) the forward rate f(t. Rolls over this loan at time S for an additional term T. The net cash flows exchanged in the forward plus hedge are independent of the value of f(S. As the hedge may underperform in the event of credit deterioration. at a rate of f(S. indicative of the rate paid by a high-credit quality bank. We refer to this expression as the composition relationship. S+T). The arbitrage argument assumes that the bank will be able to borrow at LIBOR at time S. t . but this can be hedged if the bank 1.t. If an issuer pays LIBOR now.S)S) for a term S. S + T )) < (1 + S +T f (t . which simply diffuses. earning interest at a rate of f(t. may be unable to borrow at LIBOR at a future time S > t. This suggests that − dS − dt d − dt d d (2) (1 + S f (t . The value of R(t. much of the risk has been systemic rather than idiosyncratic. In the work of CollinDufresne and Solnik (2001). LIBOR is a rate with refreshed credit quality. paying interest at a rate of f(t. However. this value is determined by the requirement that the net cash flows at time S+T vanish.S. as evaluated at time t. S + T )) = (1 + S +T f (t . comparing swap rates and AA bond yields. S.S). it relates the value of forwards of different maturities and is an essential tool in yield curve bootstrapping. 2. Deposits 1/(1+ f(t. Collin-Dufresne and Solnik demonstrated how these models could explain the relative values of long-dated securities. they may simply be unable to borrow. and to borrow beyond a certain amount. t . 3. the risk of credit deterioration is treated as idiosyncratic.S. LIBOR has been modeled as a rate with refreshed credit quality and the effect of credit deterioration of LIBOR-quality counterparties on asset prices has been analyzed.6 f(t. Borrows 1/(1+ f(t.t. t . S + T )). or liquidity very limited.S)S) for a term S+T at time 0.S+T) denotes the forward rate for borrowing at the LIBOR rate from time S to S+T. S . but not in conjunction with moves in LIBOR. they may have to pay interest rates beyond their base funding rate.S+T). a bank that can borrow at LIBOR at an earlier time t. we examine a related phenomenon. they are known with certainty at time t. such as a bank on the LIBOR panel. 360 360 360 dx represents the number of days until time x. individual credit spreads can ‘jump’.S+T). applied to the relative pricing of short-dated derivative and cash securities.t. most notably the work of Collin-Dufresne and Solnik (2001).

we still assume that Eurodollar futures. and this will reduce the aggregate amount of distressed assets that the institution will have to sell at a loss. as an institution’s funding rate depends both on its credit quality and the market liquidity for its debt. accrued over the lifetime of the transaction. illiquidity affects the relative prices of these instruments by virtue of its presence in the underlying interbank lending market. illiquidity has a significant impact on valuation. as expressed in equation (2).g. It is sometimes termed rollover risk and is common to all financial institutions. The bank earns the bid rate on the deposit. however. 8 The swaps and Eurodollar futures markets are highly liquid. When executing the hedge to the forward agreement. When a liquidity crisis strikes. . He and Xiong (2010) incorporate rollover risk into a structural model of default to capture this effect. when hedging the bank uses long-term funding to buy shorter-dated assets. such as greater bidask spreads. Note that if one executes the reverse of the forward agreement. however. Liquidity effects are relevant when constructing yield curves from treasury securities. for instance. such as the treasury market. or to incur costs in liquidating assets in order to service debt. In the discussion in this paper. Santos and Scheinkman (2009). they will incur a loss liquidating these assets 6. this can have a significant impact on the validity of the composition relationship. The potential for an individual institution to have marginal funding costs above LIBOR. Particularly in an environment in which funding is limited. further consequences of limited liquidity in the interbank market. such as the hedge to a forward agreement. for instance. These authors develop a model of liquidity spirals. in which market and funding illiquidity reinforce and amplify each other. There are. institutions hoard liquidity. and they incur a cost for engaging in transactions that require short-term funding 7. In other markets. as they rely on short-term funding to purchase long-maturity assets. The hedge to the forward agreement is an archetype of the aggregate set of transactions executed by financial institutions. That is. and illiquidity in this market is far more severe and consequential than illiquidity in the market for derivatives. this risk will lead to an increase in forward LIBOR. by Brunnermeier and Pedersen (2009). Brandt and Kavajecz (2004)). There is a benefit to having the deposit mature at the intermediate time. will lead to violations of the composition relationship. pushing up the slope of the term structure. as some treasury notes (e. Absence of arbitrage then implies that 6 The connection between illiquidity of assets (market illiquidity) and constraints on funding and capital (funding illiquidity) has been explored. 7 Rollover risk can also accelerate or catalyze bankruptcy.7 punitive that it may be preferable for them to raise cash by liquidating assets. This is the risk that institutions face in the advent of a liquidity crisis. swaps (and FRAs) remain liquid relative to the interbank lending market 8. Illiquidity in the interbank market has the consequence of increasing bid-ask spreads. but pays the offer rate when borrowing. see Bolton. If a liquidity crisis in underway at that point. as it entails funding a longer-term deposit with two shorter-term loans. To the extent that a crisis will increase funding costs for all banks. then the hedge entails a deposit that is to be rolled over at time S. The violations of the composition identity that we have discussed are due to a combination of credit and liquidity risk that cannot be easily disentangled. Market and funding liquidity are also referred to outside and inside liquidity. newly issued notes) trade at a premium due to high demand and limited supply (see. the bank would then have a shortfall equal to the value of the bid-ask spread (determined at t = 0). the maturing deposit can be used to replenish cash on hand.

S + T )) < (1 + S +T f (0. Tanaka and Wong (2009) to price cross-currency swaps with basis risk. as well as a series of separate forward curves. Fujii. but has failed during the credit crisis. but this bound depends on the bid-ask spread at time S (which is not known at time 0).e. Furthermore. one month. S . It is more difficult to design a hedging strategy with a minimal set of hedging instruments. Their relationship would be more complex than the composition relationship that follows from traditional arbitrage arguments.g. one obtains a lower bound for the LHS of the above equation. three month. several working papers proposed modifications of traditional bootstrapping techniques and pricing formulas so that they will work in the market conditions during the credit crisis 9. Mercurio (2009) provides a theoretical justification for this procedure. Eurodollar futures contracts provide a great deal of information that can be used to construct the forward curve with a spanning tenor of 3 months.8 (3) (1 + dS d − dS d d f (0. Morini (2009). using. works out an underlying credit or liquidity model that ties together the different forward curves. Developing and analyzing underlying models of credit and liquidity that explain the 9 See Mercurio (2009). but there are a limited number of these instruments with sufficient liquidity.) that loosely correspond to market FRA rates. there is limited market information available to construct these curves. etc. Beginning in 2009. In this case. First of all. market. Bianchetti (2010).0. S ))(1 + S +T f (0. it would be advantageous to develop models that relate forwards of all spanning tenors.g.. as in Mercurio (2009). . e.. it does not explain the direction of the violation. however unlike the prior argument appealing to credit risk. S + T )) + S +T (bid − ask spread (0)) 360 360 360 360 One can reverse the argument. the requirement that one model a set of forward curves (one per spanning tenor) rather than a single forward curve makes fixed income valuation and risk management computationally far more complex. i. 6 months) can be inferred from FRAs and swaps (with floating rate frequencies of twice per year). Shimada and Takahashi (2010) and Pallavicini and Tarenghi (2010) and Andersen and Piterbarg (2010). In the U. Some information for other spanning tenors (e. a market model approach that works with separate diffusions for LIBOR rates of each tenor. one for each tenor of LIBOR (e. relative credit and liquidity risk between borrowing in different currencies. Kenyon (2010). The analytics are similar to those proposed by Kijima. These authors also address the pricing of interest rate derivatives given multiple curves based on different LIBORs. Note that the presence of a bid-ask spread is consistent with the violation of the composition identity.g.0. They introduce a separate discounting curve to present-value cash flows. along with Eurodollar futures and possibly cash LIBOR. These models would also guide one in developing strategies to hedge interest rate risk with a more limited set of hedging instruments. In this situation. so that the hedge requires borrowing over time S + T. Ametrano and Bianchetti (2009).S. It would depend on model parameters that capture the credit-riskiness of the market participants that trade derivatives. None of these papers. and a deposit that is rolled over at time S. This new framework for bootstrapping yield curves and pricing interest rate derivatives has several distinct shortcomings. Eurodollar Futures and OIS-LIBOR basis swaps. One could then calibrate these model parameters using market data about FRAs and swaps with only a few different spanning tenors. six month. however.

S+T). A FRA is structured in the following way: the seller must pay. 6 and 9 months and T = 3 months and 6 months. S . with cash LIBOR prices r(t. S + T . The seller’s position can be replicated by a long position in the underlying asset – i. d S +T − d S d s − dT r (t . financed by borrowing until time S. and a long (short) position in a zero-coupon bond maturing at S. comparing FRA contract market rates f*market(S. S + T ) − f ).S) and r(t. We begin with an analysis of mispricing of FRAs. So. we will be able to analyze how violations of the composition identity (1) depend on the underlying tenors. a short (long) position in a zero-coupon bond maturing at T. S + T ) = ( − 1) . receive a zero-coupon bond maturing at time S+T with face value (1 + f(dS+T -dS)/360) in exchange for a fixed payment of $1.S+T) is the LIBOR rate fixed at time S that has a maturity of T. The arbitrage argument implies that the value of the FRA at time t on a rate with maturity T that is fixed at time S is then − dS d 1 + f S +T 1 360 (5) . 3. the amount per unit notional (4) d S +T − d S ( 360 r( S .9 relative values of fixed income instruments during the credit crisis is one of the primary goals of this paper. S ) 1 + r (t . at time t. The arbitrage argument that leads to the price of the FRA constructs a riskless portfolio from a long (short) position in the FRA. which are transacted over-the-counter. the bond issuer will be able to fund at LIBOR then. . Eurodollar Futures contracts depend solely on three-month borrowing rates.e. This can be re-expressed as a forward agreement to. depend on underlying rates of various tenors. of course. This assumes. S+T) with rates f*(S. FRAs.e. − V (t . which queries various sources. and borrowing at LIBOR until time S. r(S. i. S +T) calculated using equation (5). Therefore. S + T ) 360 f is the fixed rate specified in the FRA contract. Data for FRA contracts 10 span the period from January 2000 until June 2009. The arbitrage argument fails if the bond issuer cannot default or fund at LIBOR at time S. d S +T − d S 1+ r( S . a zero-coupon bond maturing at time T. S + T ) 360 360 Market data for FRAs specifies the contract rate f * which ensures that the FRA has value zero. we expect d − dt r (t . using FRA rates. Forward Rate Agreements (FRAs) and Eurodollar Futures are derivatives that are used to lock-in one-period lending rates. S ) 1+ 360 360 We check this relationship empirically. that the zero-coupon bond will have a yield of LIBOR at time S. two days after time S. by lending at LIBOR until time T. Inconsistencies in the Pricing of Forward Rate Agreements and Cash LIBOR rates. for S = 3. S + T ) 1 + S +T 1 360 (5) f * (S . 10 The data comes from Bloomberg. or equivalently. f ) = d S − dt d S +T − d t 1+ r (t .

It first falls below -20 basis points in August 2007. It subsequently oscillates between -10 and -40 basis points until fall of 2008. is computed by polling banks at 11 a. Figure 1: Spread between forward rates inferred from cash LIBOR and FRA contract rates. in London. A similar analysis can be applied to a comparison of 1-year par swap rates and swap rates calculated from cash LIBOR rates.m. The differences of the twenty-day moving average remain below 10 basis points from January 2000 until August 2007. This follows from the inequality in equation (2). This is what would be expected if the risk of deterioration of bank credit was significant enough to affect the FRA-cash LIBOR relationship. In that case. however. GMT and 4 p. During the crisis period. forward rates implied by FRA prices are considerably lower than those computed from LIBOR. averaged over 20-days to remove most of the impact of asynchronicity. using the . LIBOR. The market FRA contract dates reported are taken at the end of the NY trading day. but certainly changes in the market between 11 a. On most days. The LIBOR rate does not reflect the price of an actual transaction at a specific time. in a one-year swap (evaluated. we take twenty-day moving averages of the data. To remove the impact of asynchronicity between LIBOR and FRA data. which dictates that forward LIBOR from period S to S+T would be less than the value inferred from cash LIBOR for periods S and S+T.10 The results show a dramatic change in the difference between market and calculated rates beginning in August 2007. This coincides with the market dislocations associated with the collapse of Lehman Brothers. and it is plausible that they are relatively uncorrelated from day to day. one would expect these differences to be small (a few basis points). when it spikes below 100 basis points. ET will lead to differences between our market quotes for FRAs and the values computed from LIBOR.m. the differences would mostly disappear when averaged over a number of trading days.m. For instance.

many one-year Euribor swaps are structured so that the fixed payment is made once at maturity. Next. at t = 0) in which the fixed payments are made semi-annually. Each contract matures two London business days before the 3rd Wednesday of each month. their payoffs are not exactly the same.1) (1 + 360 360 (6) K1 = . Futures and FRA contracts not only differ in the timing of their cash flows. Using standard arbitrage arguments. the difference between market and calculated swap rates grew considerably. Again. this is effectively similar to the margin agreement associated with Eurodollar futures contracts. when the swap rate data is taken. we turn to an analysis of the relative pricing of Eurodollar Futures contracts and cash LIBOR rates. with the buyer or seller posting margin. In practice. the March. most forward rate agreements are struck as part of a larger derivatives portfolio. This behavior is observed for other currencies. ) 2 ) d12 r (0. September and December contracts are traded most heavily. ) + 2 360 360 360 360 360 the rates r(0. Daily changes in the value of the FRA will affect the amount of collateral that needs to be posted. standard arbitrage arguments imply that the par swap rate is: 1 d 6 r (0. and this varies between different counterparties.1) are 6 and 12 month LIBOR. The primary difference is that the FRA payoff (maturing at time S on a rate that extends to time S+T) has a factor in the denominator that discounts from time S+T to S. it surges up to about 80 basis points in September 2008. the Eurodollar futures contract does not. however as the collateral margin requirements depend on the specific details of the bilateral collateral agreement between counterparties.1) + r (0. while FRA payments are exchanged at maturity. Until the summer of 2007. which is collateralized. The Eurodollar futures contract differs from a FRA in that it is marked-to-market daily. reaching about 100 basis points in September of 2008 and falling to about 40 basis points in early 2009. d12 t6 1 d 6 t12 − t6 t12 r (0. the difference between these quantities is a few basis points prior to the credit crisis.Et[3 month LIBOR(S)]). while the floating rate payments are semi-annual.100* 3 month LIBOR fixed at T). For instance. Arbitrage arguments imply that the corresponding one-year Euribor swap rate should then equal 365/360 multiplied by 12 month Euribor. ½) and r(0.11 convention above. one can show that the quoted price of the Eurodollar futures contract with maturity S should satisfy P(t) = 100 (1 . Eurodollar futures contracts are traded on the Chicago Mercantile Exchange (CME). A single Eurodollar futures contract of maturity T is settled at date T + 2 with a value of V(T) = $2.500*(100 . . June. however. The Futures-Forward Basis. while t6 and t12 denote the number of 30/360 days in the next 6 and 12 months. market quotes for 1-year swap rates were generally within a few basis points of the value calculated from this relationship 11. It will not be exactly the same. With the advent of the crisis. 4. 11 Much of this difference in basis points is presumably attributed to time of day differences between the LIBOR quote and the market level of interest rates at the close of the day.

. It will not equal the forward rate that is inferred from FRAs.e. i. Vasicek or Cox-Ingersoll-Ross). before the financial crisis. here M(S) is B (0. For the period of the financial crisis.12 with the expectation taken in the risk-neutral measure. using equation (5). This term is often referred to as a ‘convexity correction’. the results look just like the difference between forward rates inferred from FRAs and forwards inferred from cash LIBOR.01. We refer to this difference as the Eurodollar futures-forward basis. The product σrS is typically of order .g. In previous empirical work on the futures-forward basis. inferring futures rates directly from Eurodollar futures contract prices. one can see that the convexity correction is of magnitude –(σrS)2f(S). a generously large value of .g. . with σ representing the volatility of the futures rate rS. There has been a considerable amount of study devoted to the difference between the rate inferred directly from the quoted price of the futures contract (subtracting the price from 100 and dividing by 100) and the forward rate (inferred from contracts that are not collateralized). Assuming. and of the sign opposite that would be explained just by the convexity correction.02 for σrS implies a futures-forward basis of less than two basis points for contracts maturing within six months. and arrive at an expression for this basis. A very general result. When we measure the basis using our data.S) is a S-maturity zero coupon bond. For short maturity contracts this correction is small. M ( S )) . e. appearing in Hunt and Kennedy (2000). The twenty-day moving average of the basis reaches 130 basis points in fall of 2008. From this formula. f(S) is of order one or less for S < 1 year. the forwards have been computed from cash LIBOR rates. it always remained below 10 basis points. the discrepancy is far larger than a few basis points. this expectation depends on the dynamics of the interest rates. Given a particular interest rate model (e. As LIBOR is a non-linear function of bond prices. S ) the value of a money-market account at time S and B(0. the particular interest rate model that we choose and its parameters. is that the futures-forward basis equals − cov(rS . and forward rates from cash LIBOR. for instance. one can compute the Eurodollar futures contract price exactly.

The sign and magnitude of the basis is opposite and far larger than that observed using data from the 1990’s. While the upcoming Eurodollar futures contracts are extremely liquid. Additionally. and this may 12 Earlier studies on the futures-forwards basis examined longer-dated contracts. . one can infer the discrepancy between forward rates implied by FRAs and futures rates from Eurodollar futures contracts. using rates inferred from cash LIBOR to those from FRA contract rates and Eurodollar Futures (neglecting the convexity correction). From the same plot. the FRA market is somewhat less liquid and transparent. The discrepancies are larger in the earlier part of our dataset. it was observed by Grinblatt and Jegadeesh (1995) that the basis could not be explained by credit risk. This may in part be due to asynchronicity in the futures and FRA data. as the FRA maturities roll each day. These small differences are likely not simply due to the convexity correction. we only observe very small discrepancies of a few basis points at most between implied FRA forward rates and Eurodollar futures rates. while the future contract maturities are fixed on the third Monday of the month. as the sign was wrong. and show no substantial increase during the financial crisis. we expect only a small difference due to the convexity correction. We used cubic spline to interpolate futures rates.13 Figure 2: Spread between 3 month forwards maturing in 3 months. the comparison requires interpolation of future contract values. In that period. In this case. The twenty-day moving average of this basis is shown. which is approximately proportional to the square of contract maturity. for which the convexity correction. is far larger. 12 Indeed.

of former LIBOR-paying counterparties no longer being able to borrow at LIBOR) that caused the standard arbitrage argument to break down. In fact. it was standard practice to use the composition identity to infer these 6-month forward rates. one has to just fund the additional amount required for posting margin for the futures contracts. Eurodollar futures are based on 3-month LIBOR. swap rates are generally used. This should not significantly impact the relative pricing of FRAs and Eurodollar futures. The FRAs based on 3-month LIBOR that we have examined above are 3 to 6 (3 X 6). In particular. sequential contracts based on 3-month LIBOR with contracts based on 6month LIBOR and sequential contracts based on 6-month LIBOR with contracts based on 12month LIBOR. We compute anomalies by comparing sequential FRA contracts based on 1-month LIBOR with contracts based on 3-month LIBOR. and using these to calibrate a yield curve should be sufficient to price interest-rate derivatives based on 3-month LIBOR. This is a consequence of the failure of the composition identity and the resulting relationship expressed in equation (2). i. as Eurodollar futures contracts are more liquid. When this fails. In summary. The forwards implied by FRAs and Eurodollar futures. To build the very long-end of the yield curve. executing the hedge does not require one to borrow or lend the entire notional amount.t+T) with T = 3 months. there are further inconsistencies in relative pricing of derivatives that make interest rate derivative pricing considerably more difficult. When given a swap. however. It is the additional credit and liquidity risk inherent in this market (e. three months. the implication of this is simply that one should not use longer maturity cash LIBOR rates to determine the yield curve. 5.. 6 to 9 and 9 to 12 month.g. e.e. derivative prices should be used to calibrate any yield curve that is to be used for pricing derivatives. we define . Contracts mature one through 21 months in the future. it is indeed standard practice to use them in yield curve construction. If one is building a model to price interestrate derivatives. Poorer data or less liquidity may have caused these discrepancies to be somewhat larger in the earlier years of our dataset. 6-month LIBOR. one must then extract 6month forward rates from the yield curve. consider FRAs based on both 3 and 6-month LIBOR. There is considerable liquidity in the Eurodollar futures market extending out several years. there are extremely large differences between forwards inferred from cash LIBOR and derivatives. they are based on r(t. cap or swaption based on LIBOR with a different tenor. are nearly identical. If the composition identity were to hold. Instead. Eurodollar futures or FRA prices should be used. Eurodollar futures are not sufficient to price these other interest rate derivatives.14 contribute to pricing discrepancies. the relationship between forwards inferred from FRAs was based on hedging the FRA with borrowing or lending in the interbank market. we could use these FRA contract rates to determine the rates for 3 to 9 month and 6 to 12 month FRAs. six months and one year. Our FRA dataset consists of contracts with underlying tenors of one month. Instead. If one enters into a FRA and then hedges the FRA with Eurodollar futures contracts. Practical Implications for Yield Curve Building and Pricing of Derivatives The data so far illustrate that during the crisis.g. Before the credit crisis. In contrast. As a simple example of this.

First. With this filter. t + T + iτ ′))] τ i =1 The quantity η represents the excess (continuously compounded) yield that one would obtain. particularly if the FRA is thinly traded. when data asynchronicity is more likely to be a problem. FRA rates are quoted with bid ask spreads ranging from 2 to 5 basis. If one of the spikes occurred at the end of the day. This is particularly relevant for the FRAs with underlying rates of 6 and 12 month LIBOR. a persistent anomaly of 10 basis points or so over a period of many days likely is meaningful. t + T + τ )) − ∑ log(1 + τ ′f (t . We apply a filter to our data. with larger bid-ask spreads typically attributed to FRAs with underlying rates of 6 and 12 month LIBOR. 1 τ τ′ . for different FRAs. compared to locking in a sequence of reinvested interest payments beginning at time T with shorter terms τ′ that span (t+T. … t+T + τ). t+T + τ′. low and high FRA rates. Furthermore. We observe anomalies far greater than 10 basis points. τ ) = [log(1 + τf (t . and as well removing data on days with particularly high volatility. Figures 3 and 4 illustrate the behavior of a selected set of FRA anomalies during mid2008 (between the demise of Bear-Stearns and before the default of Lehman brothers). that an anomaly of 5 – 10 basis points is not particularly significant. We use closing prices. τ ′. along with many of the FRA rates spanning the period November 2007 through March 2008. if at time t. However. note that each anomaly involves the relationship between long and short positions in 3 or 4 FRA contracts. T . t + T + (i − 1)τ ′. They also contained occasional spikes in the FRA rates during the day. t + T . one locked in interest payments (spanning the period t+T to t+T + τ) for a FRA that matured at time T on underlying LIBOR of term τ. η should be identically zero. nearly all of the FRA rates from the period September through December of 2008 are rejected. we were able to examine plots of intraday prices for portions of the dataset (in the latter part of 2009). We expect to observe small non-zero values of η due to the effects of asynchronicity and bid-ask spread. close. this would lead to an outlying FRA rate which was significantly off-market. We do retain most of the data for 2009. as well for the calendar year 2009. With standard arbitrage pricing theory. This should have the effect of removing closing quotes that occur on the infrequent spikes. which are less frequently traded. This means that on a given day. particularly for the more liquid contracts. along with an indication of both bid and ask for the closing rates. these spikes were more prevalent for less liquid FRAs. these may not represent exactly simultaneous quotes. Our dataset contained open. The intraday plots indicated that there were significantly fewer trades in the 6 and 12 month LIBOR FRAs. rejecting FRA rates on days in which the open and high quotes or the close and high quotes differed by more than 15 basis points.15 (7) η (t .

This data is from the early months of the credit crisis. .16 Figure 3: Anomalies. representing the excess yield obtained in investing at longer-term FRA rates rather than a set of shorter duration rolling contracts.

17

Figure 4: As in figure 4, except the data for the anomalies spans 2009 and the first half of 2010. The anomalies between 1-month and 3-month LIBOR FRAs, for different contract maturity dates T, tend to move in tandem. As a function of T, the term structure is downward sloping in 2008, and through May of 2009. In the latter part of 2009, however, the term structure inverts, and becomes upwards sloping. In the plot of 2009 data, we also illustrate the behavior of anomalies between 3 and 6 month LIBOR and 6 and 12 month LIBOR FRAs. By the end of 2009, the FRA anomalies corresponding to the shortest maturity T, with underlying rates of 1 and 3-month LIBOR are small enough to be immaterial, while the longer-dated FRA anomalies with longer underlying rates are still significant. Anomalies increase again in spring 2010, concurrent with the Greek debt crisis. The results illustrated in figure 2 show that three month forward rates inferred from FRAs and Eurodollar futures are nearly identical during the crisis. Therefore, the standard procedure of building yield curves using Eurodollar futures prices would lead to mispricings of six to twelve month FRAs by as much as 40 basis points in early 2009. These anomalies are also present in the FRA rates based on Euribor. For instance, for Euribor-based FRAs, the anomaly η(t, ¼ , ¼ , ½ ) has an average value of 1.3 bp before the crisis (from 1/06 through 6/07). This is smaller than the FRA bid-ask spread. Between 1/09 and 8/10, the average of this anomaly equals 19 basis points, which also is the average of this anomaly over this time period when the underlying rates are USD LIBOR.

18

This anomaly greatly complicates the practice of curve building and derivative pricing. It is no longer sufficient to build a single forward curve, based on inferences of forward 3-month LIBOR. Instead, to price derivatives based on underlying LIBOR rates of differing tenors, one needs a series of forward curves, e.g. a curve based on estimates of forward 1-month LIBOR, 3month LIBOR, 6-month LIBOR etc. as well as a riskless curve used to discount cash flows 13. In principle, one could extract this information from FRA contract rates that span (t X (t+1)) months, or (t X (t+3)) months or (t X (t+6)) months. Liquidity rapidly diminishes in the FRA market for maturities greater than one-year or so. This procedure would therefore only work at the very short-end of the yield curve. If one then has to price derivatives that mature in several years, more market information is needed to estimate η(t, T, …, …) for T well beyond one year. This information could come from the market price of swaps with floating legs that depend on LIBORs of tenors other than 3 months, i.e. both fixed-floating LIBOR swaps and basis swaps in which the receive and pay legs depend on LIBORs with different tenors. 6. Empirical Analysis of Anomalies. Given that we have observed the breakdown of relationships between derivative prices, we now turn to an empirical analysis of the source of these anomalies. The goal of this analysis is to assess which market factors are correlated with these anomalies. The results can then potentially be used to suggest hedges for portfolios with valuations that depend on these anomalies. They can serve as a guide in isolating the appropriate variables (e.g. measures of default or liquidity risk) that ultimately must be used in modeling the pricing anomalies. For market factors that serve as proxies for credit and liquidity risk, it is natural to consider the spread between LIBOR and the `risk-free’ or bank funding rates as well as bank CDS spreads. To measure the former requires identification of the `risk-free’ and funding rate. It is not necessarily apparent how to choose the risk-free rate. In past academic literature, e.g. Collin-Dufresne and Solnik (2000), rates inferred from treasury bills and bonds have been chosen as risk-free. These instruments are highly desirable not only because they have minimal default risk, but because they are very liquid. For instance, for market participants who want to short bonds (e.g. through reverse repo), it is important to be able to quickly purchase these bonds on the market. The only bonds that generally have enough market liquidity to enable swift repurchase are treasury bonds. This creates excess demand for them, potentially lowering their yield below the true risk-free rate. This can be modeled as a liquidity convenience yield, as in Grinblatt (2001). The degree of liquidity, however, varies from one treasury instrument to another, usually depending on how recently it has been issued. Due to these characteristics, treasury rates are not typically used by practitioners as the risk-free rate. The relevant rate that a market participant must consider in evaluating an arbitrage strategy is their funding rate. The return on a risky security depends on its excess yield over the funding rate; this should increase with the security’s riskiness. This suggests that an appropriate metric to measure liquidity and credit risk is the difference between the return of a risky security and a funding rate.

13

Derivative transactions are assumed to be collateralized with minimal credit risk, so that their cash flows should be discounted at a riskless rate. For more elaboration on this, see the next footnote.

19

Purchases of bonds by market participants are financed through repo operations; the funding rate for these is the repo rate. Most over-the-counter (OTC) derivative transactions between financial institutions are collateralized or secured. Fed Funds is the interest rate that is most often paid on collateral posted for OTC derivatives transactions. When a bank receives collateral, it generally has the right to rehypothecate it, i.e. post it to another counterparty as collateral. Therefore, $N of collateral will typically reduce its funding requirements by $N. If it pays Fed Funds interest on this collateral, it then effectively funds its derivatives operations at the Fed Funds rate 14. Though OTC derivative operations are not immune from credit risk, because they are collateralized, they entail considerably less credit risk than (unsecured) interbank lending, transacted at LIBOR rates. A term structure of the Fed Funds rate can be inferred from Overnight-Indexed-Swap (OIS) rates. OIS swaps consist of one fixed and one floating leg, which both pay off at maturity 15. The floating leg payment is proportional to the interest accrued during the swap at the effective overnight federal funds rate, determined daily and compounded over the lifetime of the swap. These swaps are designed to allow financial institutions to hedge their funding costs. Liquidity in the OIS swap market is quite good extending out several years; longer maturity OISLIBOR basis swaps are also traded, allowing one to bootstrap an effective fed funds term structure out many years 16. Figure 5 depicts three to six month forward rates inferred from 3 and 6 month OIS swaps, and compares these to forward rates inferred from FRAs, Eurodollar futures and cash LIBOR. The spread between cash LIBOR and the FRA/Eurodollar future rates is a consequence of the anomalies we observe; the spread between the implied OIS rate and LIBOR implied from FRAs/Eurodollar futures is a measure of credit and liquidity risk. Note that the two spreads are of the same order of magnitude and appear to track each other.

The effective Fed Funds rate is as well a rate paid for unsecured overnight lending. As it is an overnight rate, it is often argued that this rate is effectively risk-free, though this argument seems less convincing if applied at the height of the credit crisis. There is, as well, an overnight LIBOR rate. During the height of the credit crisis, overnight LIBOR spiked several hundred basis points over Fed Funds, although both represent the interest on overnight, unsecured loans between financial institutions. Overnight LIBOR, however is a ‘polled rate’ among large international banks operating in London, while Fed Funds represents the interest rate typically paid by large U.S. banks to smaller U.S. banks for overnight deposits. Thus, the rates operate in different markets, and cannot be arbitraged to an unlimited degree. The rationale for using ‘Fed-Funds’ as a risk-free rate rests largely on its role as the interest rate paid on secured transactions (e.g. collateralized derivatives) between banks. Consequently, over the last few years, market practitioners have moved towards using rates inferred from OIS swaps to present value cash flows in OTC derivatives, such as LIBOR-based swaps. 15 OIS swaps typically have a one-day lag between maturity and settlement. This leads to a very small amount of convexity in their valuation (as explained by Henrard (2008)), which we ignore in extracting forward fed funds rate. 16 There is, however, no analogue of the OIS market for repos with a great deal of market depth. This is one reason why it is preferable to use the spread to Fed Funds rather than the general collateral repo rate as a measure of liquidity and credit risk.

14

government. Lloyds and Rabobank. Figure 6 compares the 1-4 month FRA anomaly η (t . we compute the average daily 5-year CDS spread for 11 of the 16 members of the US dollar LIBOR panel 17. and then increase in the first half of 2010. we observe that overall they all do trend downwards through the latter three-quarters of 2009. From the plot of the spreads in 2009 and 2010. During this period of time. possibly creating 17 These include Bank of America. . CDS spreads and the anomalies might not move coherently. JP Morgan. the LIBOR-OIS spread and the average bank CDS spread. but that there are periods of time in which large moves in CDS spreads are not accompanied by similar changes in the LIBOR-OIS spread or the anomalies. 1 1 1 . RBS. and then through 2009 and much of 2010. there were widely publicized fears that Citigroup and perhaps Bank of America would be taken over by the U. Just as 5-year yields may not track three or six-month yields. Credit Suisse. UBS. bank CDS spreads surged up by 50%. Deutsche Bank. while the anomaly and OIS-LIBOR spread remain relatively flat. Specifically. Citigroup.S. The first plot depicts steady growth in the CDS spread from November 2007 through April 2008. during the first two months of 2009. the quality of CDS data for the remaining five LIBOR panel members was not as good as it was for these eleven banks. HSBC. There is a large maturity mismatch between CDS spreads and the anomalies that we measure. ) . over the time period 12 12 4 extending from 2007 until mid 2008 (the early stages of the credit crisis). Another measure of the credit and liquidity risk of financial institutions is their credit default swap (CDS) spread. In particular. while the anomalies and LIBOR-OIS spreads only increased slightly. FRAs. Eurodollar futures and OIS swaps. Barclays. as a metric. .20 Figure 5: A comparison of forward rates inferred from cash LIBOR.

21 losses for long-term bondholders. Figure 6: A comparison of FRA anomalies. the forward OIS-LIBOR spread and a measure of average bank credit default swap spreads. and would quote higher values of LIBOR in the daily polls. and assume mean values of 0.02 and 0. The lack of consistency between the interbank lending and CDS markets is also reflected in the behavior of individual bank LIBOR quotes and CDS spreads over time. It is therefore plausible that confidence in the security of interbank lending would not diminish even as CDS spreads widened. This would be expressed by a positive rank-order correlation between LIBOR quotes and CDS spreads. the Spearman and Kendall correlations between LIBOR quotes and CDS spreads vary from about -. shortterm) and discordant dynamics of their respective anticipated recovery rates. one would expect that banks with higher CDS spreads would pay more to borrow on the interbank market.5. The behavior of CDS spreads and measures of interbank lending risk may differ considerably both due to discrepancies in tenor (long vs. Naively. This is consistent with the suggestion that lenders believed that interbank loans to these banks . this is reflected by differences in the markets’ expectation of recovery on interbank loans versus long-term bonds upon default.5 to . Investors may have believed that the government had and would presumably act in a manner to keep financial markets functioning.04 that are insignificant. and would therefore want to ensure that interbank lending agreements were honored. Formally. From August 2008 until August 2010.

This is because some potential regression variables (e. these authors analyze data from 2007 and find that banks with higher CDS spreads do not quote higher LIBOR rates. we also perform a regression analysis. while others. although they argue that LIBOROIS and CDS spreads track each other over longer time scales. consequently. if one is not careful. such as market volatilities. The lack of correlation between CDS spreads and the pricing anomalies has significant practical ramifications when one considers modeling and hedging the pricing anomalies. we obtain these regression results: 12 12 4 18 The low or negative rank-order correlation might also be observed if some banks. LIBOR quoted by banks was only slightly below the levels of rates reported for transactions on a transparent electronic market. 1 ) . when polled. the cash LIBOR – OIS spread) are also affected by the same timing discrepancies. These empirical results suggest that any model that simultaneously explains CDS spreads and the anomalies would need to be multi-factor and/or would have to incorporate different and dynamic recoveries for interbank loans and the bonds referenced by credit default swaps. This should help to reduce the impact of asynchronicity between different FRA rates used to compute these anomalies. In the regressions. 1 . the eMID. should be roughly proportional to observed timing discrepancies. The asynchronicity in the data presents challenges for empirical analysis. none of the dependent and independent variables depend on cash LIBOR. With the FRAs used to compute the anomalies. 1 .22 would be repaid in the event of default. particularly those under distress. removing data on days when open. This cannot be done when computing weekly changes in the anomaly and using them in a regression. . Furthermore. these do not have significant explanatory value. A natural approach would be to calibrate any credit model used to price the anomalies using CDS quotes. For the 1-4 month forward anomaly η (t . To explore more thoroughly the statistical relationship between the anomalies and measures of credit. one can easily be misled by spurious correlations that are a consequence of timing differences between data measurements. The filtered data series has many gaps in 2007 and 2008. regressing weekly changes in these anomalies with weekly changes in various market factors. A substantial portion of the weekly changes in the anomalies may be due to changes in the portion of the anomalies caused by lags in the data. close and high rates were sufficiently different. This possibility was raised in the financial press by Mollenkamp (2008). This can be addressed by only including variables that depend on measurements made at the close of the market in New York. the contributions to weekly changes arising from these timing discrepancies may be strongly correlated with weekly changes in the dependent regression variables. and interest rate risk. 18 These results also are consistent with the findings of Michaud and Upper (2008). implying that it was unlikely that banks were systematically greatly understating their borrowing costs on the interbank market. Indeed. we apply the filter described in the previous section. In particular. we only perform these regressions on weekly data from 1/6/09 through 8/16/10.g. interest rate and liquidity risk. provided misleading and unrealistic LIBOR quotes. Schwarz (2009) finds that during this period. The impact of the discrepancies in measurement times can be largely eliminated when estimating the magnitude of the anomalies by taking moving averages over a number of days. we have also included as dependent variables measure of market volatility. They also find no significant correlation between day-to-day changes in the LIBOR-OIS spread and CDS spreads.

) against a set of explanatory variables 4 12 4 that are correlated with various measures of credit.58 0. VIX SPX (S&P level) R-squared 0. This is borne out by the multivariate regression results. however.01 0.33 0.0001 <.47 p value (for F stat) <.33 56.92 0.03 0.33 0. The F-statistic is much large in the univariate regressions. .59 0.34 0. Explanatory Variable(s) (weekly changes) Forward LIBOR-OIS spread Forward TED spread Forward LIBOR (inferred from FRAs) Forward LIBOR-OIS spread and forward LIBOR Forward TED spread and forward LIBOR 5 year swap rate minus forward LIBOR Average bank CDS spread Average bank CDS spread.26 0.49 1.54 0.91 40.01 0.06 0.01 <0. 1 1 1 .47 0.74 0. without 3 largest & smallest 3 month into 1 year swaption volatility squared.0001 0.94 27.01 0.05 0. η (t .96 109.34 0. ) against a set of explanatory variables 12 12 4 that are correlated with various measures of credit.01 F stat 105. against changes in potential explanatory variables.53 0.18 3. it .0001 <. the TED spread and forward LIBOR. 1 1 1 .31 0.0001 <.40 p value (for F stat) <. ) .26 20. .03 0.0001 0. are found when regressing weekly changes in the 36 month anomaly.01 <0. During this time period. so that changes in the spread were primarily due to changes in LIBOR.53 Similar results.49 0. 4 12 4 1 1 1 Table 2: Regression of the anomaly η (t .6 2.65 0. short-term OIS rates and treasury rates were close to zero with little variation.82 0.0001 <.68 1. we find that the anomaly only demonstrates a significant correlation with the LIBOR – OIS forward spread.92 0. .02 0.11 0.0001 <. Explanatory Variable(s) (weekly changes) Forward LIBOR-OIS spread Forward LIBOR (inferred from FRAs) Forward LIBOR-OIS spread and forward LIBOR 5 year swap rate minus forward LIBOR Average bank CDS spread Average bank CDS spread. liquidity and market risk.01 <0.73 1.05 0. without 3 largest & smallest 3 month into 1 year swaption volatility squared.0001 <.20 0.23 Table 1: Regression of the anomaly η (t .23 In the regressions.33 0. . liquidity and market risk.01 0.02 2.50 19.02 F stat 39. VIX (S&P implied volatility) SPX (S&P level) R-squared 0. albeit with lower R-squareds.57 0.

no-one else is lending. however. that it would be ineffective in reducing the weekly volatility of such a portfolio. There are.8 surveys show a decrease in interbank lending among large US commercial banks during the fall of 2008. This does not mean. 2008 reports "The money markets have completely broken down. however. 20 The Federal Reserve does report the level of interbank lending among US banks. are large and persistent over the crisis period. which. did change. a substantial volume of interbank loans are transacted on the “electronic Market for Interbank Deposit” (eMID) based in 19 The New York Times. This data has been interpreted by Kehoe. Most interbank lending is conducted through brokers.income strategist at Dresdner Kleinwort in Frankfurt. the regressions would yield large R-squareds if the quotes for FRAs that span one-month were often stale and did not move much over a week. however. The large R-squareds in the regression with the LIBOR-OIS spread are consistent with the explanation that the anomalies are a consequence of credit and liquidity risk. even when quotes that FRAs that span three-months. . which encompass a measure of ‘market fear’. For instance. which are more liquid. There is no data. bringing lending down to the level reported in 2006. even if one neglects other liquidity and credit effects? For this to be the case. however. One basic question that we attempt to address is: are bid-ask spreads in the interbank market in themselves large enough to explain the size of the observed anomalies. Central banks are the only providers of cash to the market. the interbank lending market ‘seized up’. the bid-ask spread would have to be of the same order as the actual anomaly. changes in the anomaly would be correlated with changes in three-month LIBOR. to quantify the degree of illiquidity in the interbank market. LIBID is sometimes quoted as equal to LIBOR minus 12. In the popular press. Chari and Christiano (2008) as signifying that the claim that interbank lending was ‘virtually nonexistent’ during the fall of 2008 is a myth. however. reflecting the typical bid-ask spread in interbank lending in the early days of the interbank market. appears to have more potential of immunizing the portfolio against this risk. as well as ‘other’ categories. Note that stale data will not explain the anomalies. "There is no market any more. Changes in the FRA anomalies will have an impact on the valuation of a fixed income portfolio. A hedge based on LIBOR-OIS basis swaps. 19 Illiquidity in the interbank market would be manifested by large bid-ask spreads.5 basis points.24 declines considerably when the LIBOR-OIS or TED Spread are used as regressors together with forward LIBOR. with no trading taking place at all." 20 By convention. alternative interpretations of these results. It is difficult. there are anecdotal reports that during the fall of 2008. but the decline is relatively modest. in the 1980’s. The above results suggests. that if a hedge were based on taking a position in the VIX or CDS spreads. on September 30. lending in a different market. as illustrated by the moving averages we have computed. indicating how much lending is carried through Fed Funds and Repurchase Agreements combined. The Federal Reserve H.5 basis points." said Christoph Rieger. however. a fixed. Note that the Federal Reserve interbank lending data applies to a different (though not mutually exclusive) set of banks from those in the LIBOR panel. In this case. gathered on LIBID. one might aspire to hedge this risk. however. 7. we would at least like to make a qualitative assessment of the degree of illiquidity during the financial crisis. that the actual bid-ask spread is currently 12. Can Bid-Ask Spreads Explain the Anomalies? In assessing the role of illiquidity in explaining the anomalies. so that LIBID (the London Interbank Bid Rate) would be considerably less than LIBOR.

restricting pairs to trades occurring on the same day. The “sell” and “buy” here refer to the action of the aggressor bank. we know whether the aggressor is buying or selling. Differences in credit quality between the borrowers engaged in buy transactions versus sell transactions. Switzerland and the US participated in this market. implies that the sell-buy spread would tend. If the aggressor is lending (selling). This. Quotes are not recorded in the dataset. the quoter can first check its identity. If the aggressor is borrowing (buying). to be higher than the bid-ask spread. we match the closest pairs of buy and sell trades. In figure 7. consistent with the terminology for ‘bid-ask’ spread. this moving average is similar to the bid-ask spread presented by Politi et al. the trade is immediately executed and money is giving to the quoter. and that the sellbuy spread does indeed reflect counterparty credit risk as well as the bid-ask spread. 3. eMID data has also been analyzed for this purpose by Michaud and Upper (2008) and Politi et al. In addition. with typical daily volumes of 2x1010 Euros. The computed spreads are averaged within each trading day. 2. on average. The impact of movements in rates within pairs can be largely eliminated by averaging sell-buy spreads over a large number of pairs of transactions. A trade occurs when a bank (the aggressor) actively chooses a living order. for each trade. The eMID data set can shed some light on the bid-ask spread in the interbank lending market. Only borrower banks are identified by codes. (2010). In addition to rate and amount. 21 . 138 Italian banks and 106 international banks from the EU. Lender banks are anonymous. Between January 1999 and August 2009. The ‘sell-buy’ spread refers to the buy price minus the sell price.25 Milan. the eMID is a quote-driven market. The bid-ask spread. Quotes are posted individually in an order book. we plot the overnight sell-buy spread. (2010). only trades are. however. The sell-buy spread between transactions is determined by three factors: 1. We examine the sell-buy 21 spread to estimate an approximate upper bound for the bid-ask spread in the eMID market. Schwarz (2009) argues that banks with poorer credit quality tend to borrow as aggressors. further averaged over twenty days. Since no quotes are available in the dataset. Movement in the level of interest rates during the time spanning the two transactions. As for the third factor. Only data on the Euro is available.

The vast majority of lending on the eMID is overnight. volumes traded on the eMID did decline. Still. on many trading days. In figure 8. In this case. then arbitrage arguments.26 Figure 7: Overnight sell-buy spread for the eMID interbank market during the crisis In the six months prior to Lehman’s default. there were no buy-sell pairs. we only average positive sell-buy spreads (some sell-buy spreads will be negative if rates fall sufficiently between the sell and buy transactions). we find that prior to Lehman’s default. as these are the terms relevant to much of the analysis of the FRA anomalies that we observed. and average to about 5 basis points. however. we cannot eliminate the impact of market fluctuations of the risk-free rate. most of the sell-buy spreads are below 10 basis points. even with a twenty-day moving average. In this case. we plot the daily average sell-buy spread for loans with three-month terms. The evidence from the eMID. relaxed to take into account bid-ask spreads (as in equation . With fewer data points. The sell-buy (and consequently bid-ask) spreads do surge after Lehman’s default. the moving average of the sell-buy spreads ranges from about two to four basis points. We examined the sell-buy spread for loans with terms of one and three months. even after Lehman’s default. If bid-ask spreads for LIBOR quoting banks were similar to those implied by the eMID data. The results for loans of terms of one month are similar. As the credit crisis progressed. the short-dated anomaly representing the excess cost of borrowing for three months versus three rolling one-month periods ranged from about 15 to 25 basis points. During this same period. This may have been due both to lack of liquidity and from competition from lending facilities set up by the European Central Bank. This will tend to overstate the buy-sell spread. is that the market did not entirely freeze up. the data was much sparser.

It is also important to note that LIBOR panel banks on average have superior credit than those who participate in the eMID market and therefore enjoy a narrower bid-ask spread than the eMID banks. however. these quotes refer to loans of ‘reasonable size’. Modeling Risky LIBOR Up to now. implying that any size effect is likely not so significant. 22 Schwarz (2009) notes that better quality credits tend to transact large loans on the eMID market. as described at the end of section three and in section four. documenting anomalies in interest rate derivative pricing. Larger overnight loans (ONL) are transacted on the eMID. Even so. these better quality credits would not tend to have credit quality surpassing the members of the LIBOR panel. . with smaller notionals traded by lesser quality credits. the viewpoint of this paper has been largely empirical. The eMID results we have presented are for much smaller notionals. The sell-buy spreads for these are only slightly larger (2-5 basis points rather than 2-4 basis points in the period prior to Lehman’s default) than those of the smaller overnight loans. When banks are asked to quote LIBOR. One consequence is that. these have a median size of about 150 million Euro. albeit with far less frequency than smaller loans. It is possible that the bid-ask spread may be larger for bigger loans. anomalies for EURIBOR are quite similar to those observed for USD LIBOR. are still insufficient to explain the observed anomalies Figure 8: Three-month sell-buy spread for the eMID interbank market during the crisis. and then performing regression analysis to explore how these anomalies are related to market-based measures of credit risk. 22 All of these points suggest that the bid-ask spread for LIBOR banks is probably at least not much greater than the sell-buy spread observed on the eMID market. while we have primarily presented anomalies for USD LIBOR. However. We note that the eMID data consists of quotes for interbank lending in Euro. 8. which generally means several hundred million Euro.27 (3)). having a median size of about 10 million Euro.

. it represents the instantaneous forward rate. u )du. u. the meaning of a forward agreement on the company’s debt. t1 . given a contingent claim. t 2 ) − ∫ F (t . when F has only two entries. are affected by liquidity risk and implicitly it is assumed that these effects are captured by the risk-adjusted loss rate. t1 . In this case. 3. We infer values of F from market FRA (forward rate agreement) quotes. but subsequently the claims are not retired.28 without additional models. t1. The instantaneous risk-free rate at time u. one can no longer infer a forward rate that spans a tenor ‘T’ (that is.g. t 2 ) = (t 2 − t1 ) F (t . With the RMV assumption. we also assume that when the models are calibrated to market prices. In the above.t. This contrasts with the assumption. Implicit in this formalism is the assumption that. it is convenient to work with continuously compounded interest rates. it is natural to view default as an event in which all claims on the defaulting company are reduced in value by one minus the recovery fraction. The instantaneous risk-adjusted rate at time u for an institution conditional on the specification that it was able to borrow at LIBOR at time t1: R(u. post default. upon default. however. that recoveries equal a given fraction of the market value of the claim (the RMV assumption). In developing these models. that default can then occur multiple times. representing the spread between risky and risk free rates as diffusion processes. We now proceed to develop and analyze models of underlying credit and liquidity that may capture the relationships between forwards of different spanning tenors during the credit crisis.t+S)). ru. t2) denotes the continuously compounded forward rate (spanning a tenor (t2 – t1) . that they effectively incorporate the impact of liquidity. v ).t. we can make sense of forward agreements on the company’s debt that expire after default occurs. They will be of the reduced form type (as developed in Duffie and Singleton (1999)). The models introduced in this section will incorporate the default risk inherent in LIBOR.t+T)) from a series of forward rates that span a shorter (or longer) ‘S’ (rates of the form f(0. e. u ) = lim v →u F (t . The formalism that we have introduced is motivated to describe losses due to default risk. We then can express the various ‘anomalies’ that we have observed as a function of ε. albeit with reduced value. if the company is liquidated and the debt fully retired after default. t1 ) = l t1 . Although we refer to the models introduced in this section as ‘credit-risk models’. In contrast. This rate equals the risk-free rate plus the instantaneous expected loss rate (loss given default multiplied by instantaneous hazard rate). t2): (8) ε (t . and to express the deviations from traditional arbitrage pricing using the following function ε(t. also often used in credit risk modeling. but continue on until their scheduled maturity. F(t. that one recovers a given fraction of the par value of a debt instrument. R(t1 . t1. t1). The instantaneous risk-adjusted rate for an institution that can borrow at LIBOR at time u: lu. It is possible. t1 t2 F (t . 2. as expressed in the risk-neutral measure. as well. becomes ambiguous. rates of the form f(0. The prices of credit-risky instruments. as the underlying bonds will still exist after default. This spread depends on 1.

. but is independent of t and therefore equals ls – rs .t) – rs does not vary with time s. Collateralization largely mitigates the counterparty credit risk. In the second appendix. which in the US market is typically the effective Fed Funds rate 23. t 2 ) = − log( E * [exp( − ∫ rs ds ) exp( − ∫ ( R( s. LIBOR is ‘refreshed’ so that it may not be the rate paid by the same cohort of banks that paid LIBOR at time t. Let us rewrite the numerator as 23 In Piterbarg (2010). on an underlying rate of tenor t2 – t1. The consequence of this is that we will discount cash flows at the risk-free rate. so we can bring the outer discount factor inside the inner expectation. In practice. E * [exp( − ∫ rs ds )] t E* represents the expectation in the risk-neutral measure. this rate is referred to as rC. We can rewrite the expression for the forward FRA rate as (10) (t 2 − t1 ) F (t . the inner expectation is conditional on the value of r at t1.29 We assume that the FRAs underlying the forward rate agreements are transacted by counterparties that fund at LIBOR and that they are fully collateralized.e. t1 ) − l s )ds ) exp( − ∫ (l s − rs )ds )] t t1 t1 t1 t2 t2 t2 ) E * [exp( − ∫ rs ds )] t In the numerator above the above expression. the rate paid on collateral. It then follows that the continuously compounded forward rate inferred from a FRA that settles at time t1. the second term captures the possibility that a counterparty that can finance at LIBOR may then see its credit quality deteriorate below LIBOR. This would be the case if the LIBOR credit spread were stochastic. t1 )ds )]] t t1 t1 t1 t2 ). t 2 ) = − log( E * [exp( − ∫ rs ds ) E * [exp( − ∫ R ( s. and then remove one of the nested expectations. we show that the anomalies generated in this case. i. In the numerator. The third term itself represents the effects due to fluctuations in the instantaneous credit spread of `LIBOR’ rated entities. the risk-free rate (r) used is the secured funding rate. though non-zero. t1 . then the anomaly ε vanishes. are still much smaller than what has been observed during the financial crisis. t1 . it is essential that any model of forward rates incorporate the characteristic that at a time s > t. while LIBOR was not a refreshed rate.t) – rs varies with s. is (9) (t 2 − t1 ) F (t . It does not vanish if R(s. Therefore. One can show that if R(s.

This suggests that it would be reasonable. if we assume. along with annualized variabilities for both the risk-free rates and spreads of two hundred basis points. t1 )) exp( rs ds ))) . is the following: This covariance term can be ret t1 expressed as cov(exp( − rs ds ) exp( − rs ds ). t2 < 1. t t1 t1 As in Collin-Dufresne and Solnik (2001). cov(exp(− ∫ rs ds ). we t t1 t2 t1 t2 t1 t2 t1 t2 t2 ∫ t1 t2 ∫ t2 ∫ t2 ∫ see that this term is small if the following three covariances are also small: cov(exp(− ∫ rs ds ). t1 ) − rs )ds )) . we have observed anomalies of tens of basis points. t1 ) − l s )ds ). This is the approach taken in the work of Collin-Dufresne and Solnik (2001). During the credit crisis.30 t2 t2 t2 E * [exp( − ∫ rs ds ) exp( − ∫ ( R( s. exp( − ∫ (l s − rs )ds )). however. It seems unlikely.t) – ls and ls – rs is tantamount to neglecting two covariance terms in equation (11). the lognormal model is not tractable at all. when there is a very large variation in the magnitude of spreads. Expanding this. is to work with simple models that lead to analytic expressions for ε. at least for short tenors. Ignoring the correlation between rs. conservatively. however.t) – ls. exp( ∫ rs ds )). up to one hundred basis points. t1 ) − rs )ds )) + t t2 t1 t2 t2 E * [exp( − ∫ rs ds )] cov( exp( − ∫ ( R( s. t t1 t1 t1 t1 t1 . cov(exp( − ∫ R ( s. 24 Another argument for dropping the first covariance term. t2 t2 cov(exp( − ∫ rs ds ). to neglect these terms and work with uncorrelated diffusion processes 24. This. exp( − ∫ ( R( s. Typically credit spreads models assume that the spreads obey Cox-Ingersoll-Ross (CIR) processes. This imposes substantial limitations on our choice of processes. R(s. in both cases. the possibility of jumps included as well. this would be a considerable shortcoming. Our goal. in this case. ls – rs as stochastic processes. For instance. or multiple uncorrelated spreads. particularly if we confine ourselves to calculating the anomalies for short tenors. we will model the differences R(s. t1 ) − l s )ds ) exp( − ∫ (l s − rs )ds )] = t t2 t1 t2 t1 t2 E * [exp( − ∫ rs ds )]E * [exp( − ∫ ( R( s. these terms should not exceed a basis point or so. exp( − ∫ ( R( s. e. that these covariance terms will be this large.g. t2 – t1 = ¼. the quantity ε should be of this order of magnitude to lead to these anomalies. The CIR model is only analytically tractable (in that it admits analytical formulas for bond prices) if applied to a single spread. t1 ) − l s )ds )]E * [exp( − ∫ (l s − rs )ds )] + (11) t t2 t2 t1 t1 cov(exp( − ∫ rs ds ). t1 )ds ). correlations of magnitude one. or that the logarithm of the spread evolves normally with. exp( − ( R ( s. exp( ∫ rs ds )). As we want to apply our results to an analysis during the credit crisis. Analytic solutions for multiple processes that are correlated can be obtained if we assume that the processes obey Ornstein-Uhlenbeck diffusions (with perhaps uncorrelated jumps). exp( ∫ rs ds )). does not capture the tendency of the variability of spreads to grow as spreads increase.

has a significant impact on the valuation of forward rate agreements and swaps which are off-market. it is apparent that they are proportional to the integrated variance of the instantaneous credit spread between times t1 and t2. the first two of these three covariances appear in the calculation of the Eurodollar Futures – Forwards basis. which have fixed and floating legs that take on considerably different values. this should be less than a basis point. which captures the expected deterioration in credit spread of a LIBOR-rated bank below LIBOR over the period t1 to t2. In the models analyzed by Collin-Dufresne and Solnik (2001). we also show that cov(exp( − R ( s. In the second appendix. and finds that these are large for long-maturity contracts. a small value) if discounted at a higher rate. we find that (12) ε (t . so that it represented a risky discount rate (e. This undoubtedly would not hold during the recent credit crisis. t 2 ) = − log( E * [exp( − ∫ ( R( s. this would have led to only very small changes in the anomaly ε. which is very small for contracts maturing within a year. t1 )ds )) is small. The impact of collateralization is significant for FRAs or swaps that either are off-market or are of long maturity. that considerations of derivative counterparty credit risk and collateralization should only have a very modest impact on the anomalies that we observe in this paper. t1 ) − l s )ds )]) − log( E * [exp( − ∫ (l s − rs )ds )]) − E * [ ∫ (l s − rs )ds ]. only will have a much smaller secondary dependence on this correlation. we can then infer all potential forward rates from instantaneous forwards. i. t1 25 t2 ∫ t2 ∫ t1 Shifting the rate of discounting. one can then compute the first term in (10). t1 . If we ignore the last two terms in (12). and it should grow at most linearly with t2 –t1. however. If we choose as well to model ls – rs as a stochastic process that admits analytical expression for bond When LIBOR is treated as the risk-free rate. t1 )ds ). However. assuming no collateralization of the forward rate agreement).e. This suggests that the bulk of the contribution to ε arises from the first term. This supports our claim. In any model that admits analytic expressions for bond prices. who expresses the differences between forward prices (on assets such as equities) inferred from collateralized and non-collateralized contracts as convexity corrections. when much of the risk was systematic rather than idiosyncratic. made in the introduction.31 Without the covariance terms. One consequence of this observation is that if we had increased the discount rate in equation (9). a FRA that has zero value when discounted at the risk-free rate will have value equal to the convexity correction (i. our problem becomes particularly simple: model the difference R(s. exp( rs ds )) is small as well. this correlation is assumed to be zero.t1) – ls and ls – rs. Given this. Note also that (12) does not depend on the correlation between R(s.e. exp( R ( s. These changes would be due to the `convexity correction’ terms that we have dropped in equations (11) and (12) 25.g. . t1 )ds ). however. By Taylor expanding the log and exponential. t1 t1 t1 t2 t2 t2 The latter two terms are effectively another sort of convexity correction. It is also similar to the results observed by Piterbarg (2010).t1) – ls as a stochastic process. For t2 –t1 = ¼ . given an analytical expression for ε. The anomaly ε. t1 t1 t2 ∫ t2 ∫ suggesting that cov(exp( − R ( s.

there is fear that their credit quality may deteriorate rapidly. The solution with a CIR diffusion is derived in the first appendix. t1) – ls is skewed so that financial institutions will usually maintain a LIBOR credit spread. t 2 ) = ∫ λ ( s )[1 − exp(ν ( s − t 2 ))]ds. h(u. J(s) is a Poisson process with intensity λ(s) 26. In this model.32 prices. As most banks can maintain LIBOR funding for many years. however. s. we can arrive at analytical expressions for (10). φ can increase in steps of size ν.g. In this framework. The introduction of stochastic intensity also naturally induces a correlation between credit spreads of different banks. ν. 26 We have chosen to allow the intensity to vary with time deterministically. one can choose λ(s) to be a deterministic function. a two-state continuous Markov jump process and a shifted CIR process. With a jump process. we have (14) ε (t . but with a jump event. 2v. λ(s) = λsexp(-βs) + λL(1-exp(-βs)). t1) – ls as φ(s. the anomalies we observe will also be strongly correlated with the LIBOR risk-free spread. We would like our model to have the potential to explain the stochastic behavior of the anomaly over time. The positive jump model we consider is (13) dϕ = υdJ (s ) with φ(t1. but fixed the jump size ν to be constant.g. T ) = − log( E * [exp( − ∫ h (u. e. providing the random processes driving their jump intensities are correlated. 3v. t1) – ls: a countably infinite-state positive jump process. In this model. their credit risk and funding costs may suddenly increase dramatically. … In its simplest guise. T )λ (u )du ) | λ (t ) = λ0 ]). would come at the expense of having to calibrate additional parameters for the second process. e. but in a period of crisis. One possible way to do this is to use a stochastic Poisson intensity. t1) – ls would behave. This. t1 . s T When λ(s) obeys either the Vasicek or CIR diffusion. The model could have as well been extended to include time-dependent jump sizes. T ) ≡ 1 − exp( v (u − T )). with λ obeying an extended Vasicek diffusion (15) dλ = a (b( s ) − λ )ds +σdW or an extended Cox-Ingersoll-Ross diffusion: (16) dλ = a (b( s ) − λ )ds +σ λ dW . a bank would find that its credit spread would tend to gradually drift up away from LIBOR. . t1). t1 t2 Collin-Dufresne and Solnik (2001) model this process as a jump with time-varying but deterministic intensity. The CIR diffusion has the advantage of restricting (with sufficiently small σ) the intensity to be positive. when the Poisson intensity is stochastic. the anomaly can be expressed as (17) ε (λ0 . a jump process would seem to better capture the way one would anticipate R(s. As shown in the appendix. the distribution of R(s. With a diffusion process. t1) = 0. Let us denote the difference R(s. t. assuming values 0. this equation can be reduced to a closedform (admittedly complex) analytical solution. We now consider three simple models for R(s.

The form of this density can be derived using combinatoric arguments similar to those at the beginning of the first appendix. with dφ = ν+ dJ+ (s) – ν.g. h (u. This model. However. one would need a model that captures the stochastic nature of the anomaly. the anomaly is very well approximated by the simpler equation: (18) ε (λ0 . .dJ(s). s. The instantaneous probability per unit time of transitioning from state 0 to state 1 is denoted by λ. 28 27 A slightly negative spread is plausible. T ) E * [λ (u )) | λ (t ) = λ0 ])du. one has explicitly Similarly. e. T ) ≈ ∫ h (u. however. In the simplest such model. but a large negative spread is not. t1 . t2 – t1 ≤ 1. In these cases. The anomaly in this case is given by (19) ε (t . 1 t1 poccup is the ‘occupation time’ density. higher moments of the distribution of the anomaly would be needed to price instruments that depend in a non-linear fashion on the anomaly. s T In particular. The two states (X = 0 and 1) are characterized by values of φ equal to 0 and ν respectively. a yield curve spread option with a payoff that is a non-linear function of the spread between 6 and 3 month LIBOR. the probability per unit time of jumping back from state 1 to state 0 is given by μ. the `short-dated’ anomaly will be quite insensitive to the value of σ (and whether the CIR or Vasicek diffusion is used). we consider a jump model formulated as a continuous-time finite-state Markov process. t. as a bank could fund slightly below LIBOR. To avoid this possibility. would lead to spreads that were substantially negative 28.g. the introduction of the stochastic equations for the intensity will have negligible impact on forward curve building (as long as the underlying LIBOR rates do not have excessively long tenors). the values of short-dated bond prices in the CIR and Vasicek models are relatively insensitive to the parameter σ. let us denote the state of the obligor at time t by X(t). given a portfolio with a valuation that was sensitive to the size of these anomalies. as in the model of credit risk introduced by Jarrow. Furthermore. The jump model described above has the shortcoming that it permits only increases in the spread φ. T ) ≡ 1 − exp( v (u − T )). With this density. as the forward curve is primarily sensitive to the average expected credit spread. the occupation time measures the cumulative amount of time (between t1 and t2) for which X equals 1. given values of a and b(s). for risk management purposes. we will consider cases in which the t2 ≤ 2.33 In this paper. One could extend the model (e. A derivation is presented by Pedler (1971). This is because the `convexity’ correction (the error term when the expectation and exponential are switched) is very small 27. as it is more generally formulated in Collin-Dufresne and Solnik (2001) to incorporate (countably infinite) negative jumps. t 2 ) = − log(∫ t2 −t1 0 poccup ( s = t2 ∫ X (u )du | X (t ) = 0) exp( −νs)ds). Lando and Turnbull (1997). This raises the question: why then bother to work with a stochastic jump intensity? Indeed.

as a continuous diffusion process rather than a jump process. t1) = ξ(t1) (so that φ(t1. The CIR++ model is typically used to model interest rates (see Brigo and Mercurio (2006)). A similar situation exists when these interest rate models are generalized to include a term structure of volatility (σ) and the volatility function is then adjusted to produce a best fit to the two-dimensional swaption volatility matrix. This is for purposes of analytic tractability. If we choose model parameters sufficient to generate a FRA anomaly of this size. 2 t2 −t1 ∫ exp( −(λ − µ − ν )s − µ (t 0 − t1 ))( λµs A third approach is to model the difference R(s. t1 . there is generally an 80% probability that the spread after 9 months 1 1 1 4 4 2 . equals a constant) and then express φ(s. This leads to the following solution for ε: (22) ε (t . As we expect that some institutions will be able to finance slightly below LIBOR. One can then directly use a Vasicek or shifted CIR process to model φ.φ(s. so that adjustments to ξ will not be sufficient to produce a perfect fit to the term structure of anomalies. κ. h ≡ κ 2 + 2σ 2 . the shift function ξ(s) is often chosen to be piecewise constant. we specify a deterministic function ξ(s) (which. it is not clear how to arrive at an analytic form for the occupation time density given stochastic (or just time-varying) transition probabilities. ) . to generate anomalies comparable to those observed during the crisis. We recall that the FRA anomaly η (t . x(t1. t2 ) = − ∫ ξ ( s )ds + t1 t2 2κθ σ 2 [(κ + h ) t 2 − t1 + log(2h ) − log(2h + (κ + h )(exp( h(t 2 − t1 )) − 1))] + 2 2ξ (t1)(exp( h(t 2 − t1 )) − 1) . t2 − t1 − s I0 and I1 are the modified Bessel functions of the first kind. we have restricted the transition probabilities to be constant. t2 ) = ν (t2 − t1 ) − log[exp(−(λ − ν )(t2 − t1 )) + I 1 ( 2 λµs (t2 − t1 − s ) ) + λI 0 ( 2 λµs(t2 − t1 − s ) ))ds ]. the model parameters must be chosen so it is very likely that the spread above LIBOR for any given bank that initially funds at LIBOR will grow large rather quickly. The shifted CIR model admits an analytic solution. the anomaly ε that we would like to fit has a two-dimensional term structure. during early 2009. σ and θ. t1) = 0) and (21) dx = κ (θ − x )ds +σ x dW . 2h + (κ + h )(exp( h(t 2 − t1 )) − 1) When ξ(s) is simply a constant ξ and σ2 ≤ 2. t1). Note that in our two-state Markov chain credit model. t1) – ls . t1 . One shortcoming of the shifted CIR diffusion model is that. In formulating the shifted CIR model. Note that in this case. . t1). over the Vasicek model. . in the simplest case. with levels adjusted so that the model bond prices are consistent with the term structure of interest rates.34 (20) ε (t . and has the advantage. One would hope that one could reproduce the anomaly at least quite well via adjustments to ξ(s). it κθ mean reverts to the value θ – ξ. the spread φ is bounded below by –ξ. it is reasonable to pick a value of ξ on the order of 10-20 basis points. that the variability of the spread grows as it increases. ranged between about 30 and 40 basis points. t1) = -ξ(s) + x(s.

If the diffusions for different members of the LIBOR panel were uncorrelated. There cannot be a large degree of negative correlation between all of these diffusions. we cannot generate a FRA anomaly above 30 basis points. there would be an 80% risk-neutral probability that an institution paying LIBOR would find its financing costs at least 150 to 200 basis points above LIBOR nine months later. With these values (and θ less than about 6%). in which we plot the ratio between the spread after 9 months (with 80% confidence) and the anomaly. however. . then in 9 months. to a particular FRA anomaly. nearly all the members that were in the LIBOR panel would finance at rates far above LIBOR 29.35 will be more than four times larger than the anomaly. The plot shows the ratio between the spread above LIBOR that the bank will pay in 9 months with 80% confidence. Our model is meant to capture the possibility that a few banks may have their credit quality deteriorate sufficiently so that they might be removed from the LIBOR pool (or at least be among the 25% of pool members with quotes so high that they are not included in the average that determines LIBOR). This ratio falls below 4 only when we choose a large (and somewhat unrealistic) volatility parameter σ and a small mean reversion strength κ. If the shifted CIR diffusion model were used with the more reasonable parameter values we have checked. It seems exceedingly unlikely that nearly all of the members of the 29 The situation would be even more extreme if they were all positively correlated. Figure 9: This figure illustrates the difficulty in generating a large anomaly in the Shifted CIR Diffusion Model without also predicting a very high (risk-neutral) probability that any bank will see its funding rate increase far above LIBOR. This is illustrated in Figure 9. or positive definiteness of the correlation matrix would be violated.

with the jump models. θ – ξ would need to be several hundred basis points to generate the FRA anomalies observed in 2009. the market price of risk would have to be very large. cash. in which one or several financial institutions may need to liquidate assets to obtain cash. have to choose values of ν that may seem unreasonably large (e. a prime brokerage unit. In this case. one expects a risk-adjustment (from the market price of risk) that effectively would lead to a larger value of φ in the risk-neutral measure than in the objective measure. Indeed. real estate. but this parameter has no impact on the likelihood that a jump will occur and that an institution will finance above LIBOR. Filipovic and Kimmel (2007) explore generalized forms of the market-price of risk in affine models. 30 . given models that captured the potential excess rate of funding for a financial institution beyond LIBOR. This is possible because the size of the anomalies increases approximately proportionately with the jump-size parameter ν. In contrast. one can generate large anomalies while restraining the likelihood that nearly all of the LIBOR panel will finance at rates well above LIBOR. treasury securities) assets with value C(t) and illiquid assets (subprime mortgage backed securities. …) with value A(t). and it would be difficult to explain the variation in the anomaly over time through the dynamics of the parameters in the objective measure. we presume that the quotes are truthful.g. while our comments about the implausibility of nearly the entire LIBOR pool financing at well above LIBOR apply in the objective (real-world) measure. however. In the objective measure. There have been proposals to incorporate stochastic market prices of risk into interest-rate models. A time-dependent deterministic market price of risk is also incorporated into the models used by Liu. many of the institutions would probably remain in the pool. however. In the previous section. For this to occur. The shifted CIR diffusion that determines the anomaly is in the risk-neutral measure. To motivate this model.g. in such a dire credit environment. and their distressed state would be reflected in a higher LIBOR-risk-free spread. in order to provide a better fit to empirical term-structure data. along with a static market price of risk 30. 9. Duffee (2002) and Cheridito. thousands of basis points) to generate large anomalies if the jump intensity is limited. Some of these assets are pledged as collateral. it is likely that other financial institutions would then be similarly distressed.e. so we have C(t) = Cpledged (t) + Cunpledged(t) and A(t) = Apledged (t) + Aunpledged(t). indicating the interbank market is still operating and that only some banks cannot borrow and need to liquidate assets to obtain cash. i. In the risk-neutral measure. For this to be the case. let us divide the assets of a financial institution into two categories: liquid (e. see Ahmad and Wilmott (2007). we computed forward rate anomalies. We assume that many banks continue to quote LIBOR rates during this liquidity crisis.36 LIBOR pool would be financing at more than 100 basis points above LIBOR in nine months. Modeling the Impact of a Liquidity Crisis. θ – ξ would have to be far smaller (much below 100 basis points) if a significant proportion of banks are to still fund at LIBOR. Longstaff and Mandell (2006) to evaluate the credit and liquidity components of swap spreads. nearly all of the members of the LIBOR pool would have to be replaced. One may. We now model the impact on forward rate anomalies of a more severe market dislocation.

the secured debt capacity also declines as the value of pledged illiquid assets and their associated haircuts fall. leading them to charge higher rates and demand more collateral. however. If enough debt becomes due at this point. In modeling liquidity.κ2' . As long as α < κ1 . it will not be able to roll it over. Normal 2. we can characterize the state of a financial institution as: 1. the value of illiquid assets plummets. there are several possible outcomes. and the institution selling an amount a of these assets will incur a loss proportional to α. Additionally. or to obtain cash or risk-free securities that will serve as collateral for secured debt. During a liquidity crisis. the institution will have to sell illiquid assets either to obtain cash to service debt. and it will default. convert their liquid assets to illiquid assets. When these measures are exhausted. the value of its assets and the associated haircuts may 31 Covenants may restrict which assets can be pledged as collateral for new secured debt. i. Once a liquidity crisis takes place. When a liquidity crisis occurs. and will effectively entail losses similar to those incurred through selling illiquid securities. A consequence of this is that the debt capacity D(t) may be less than the outstanding debt. which we denote as αa. i. There is likely a substantial cost to selling these illiquid assets. κ2 and κ2' should be considerably less than κ1 and κ1'. Debt service requirements will be more severe if the institution has a great deal of short-term debt. the institution may also be able to liquidate sufficient illiquid assets so that its debt capacity exceeds its outstanding debt. κ1' should be only slightly less than one. 3. The institution may not be able to sell a sufficient amount of illiquid assets to bring its debt capacity up to the level of its outstanding debt. their price volatility and transaction costs and bid-ask spreads incurred through liquidation.e. it can then roll-over (or repay outstanding debt). the institution will be able to increase its debt capacity by liquidating assets. As the capital held be other financial institutions declines.e. reducing the values of κ2 and κ2' further. In default. Furthermore. At the same time. as volatility. Given a sufficient base of illiquid assets. the haircuts κ2 and κ2' will also decline substantially. This is a reflection of the possibility of significantly lower recovery from the illiquid assets. the secured haircuts κ1' and κ2' should be larger than the unsecured haircuts κ 1 and κ2. they may require a greater return on their capital. ' Dsec ured (t ) = κ 1' C pledged (t ) + κ 2 A pledged (t ). The institution can also attempt to raise capital. its debt capacity is below its outstanding debt. uncertainty and bid-ask spreads increase. Undergoing a liquidity crisis. .37 The total amount of unsecured debt that creditors should be willing to extend to this institution should then be approximately (23) Dun sec ured (t ) = κ 1C unpledged (t ) + κ 2 Aunpledged (t ). but during a liquidity crisis this will be difficult. Furthermore. The κ’s are haircuts. due to the uncertainty in their value. very few institutions will have the debt capacity that allows them to purchase these assets. The financial institution will at first use its remaining cash or sell its highly liquid securities to service debt. it may also pledge additional securities as collateral for new and existing additional secured debt 31. There will not be a competitive market in these assets.κ2 or α < κ1' . . meaning that the institution has to sell illiquid assets to roll over and service its debt.

Now let us consider the impact of a liquidity crisis on the FRA payoff plus hedge. but if the institution that executes the hedge and the FRA enters into the second liquidity crisis state.S. In these cases. so that it matures at S + T – t .t. minus the payment received from settling the FRA). What happens if a liquidity crisis is in progress at both times S and S + T? The FRA plus hedge will not have any marginal impact on how much the institution has borrowed from time S to S + T. the institution cannot borrow as much as it needs. If X(S) = 1. X(t) = 1 if there is a crisis at time t. the rate of interest paid will be the market rate f(S. the institution will need to liquidate assets to service its debt. struck at the forward rate R at which at time S 32. and has to instead liquidate assets at a loss. and additional illiquid securities will then have to be liquidated.S. as at time S. the payment is two days later. this portfolio is riskless. we shall only model the impact of losses arising from the liquidation state rather than default. t .38 increase as the market emerges from a liquidity crisis. Define X(t) to be an indicator of whether a given institution is undergoing a liquidity crisis is present at time t. otherwise X(t) = 0. so that if X(t) = 1. The marginal impact of the FRA plus hedge is that the institutions’ cash will be depleted by 1FRAPayoff at time S. we refer to the models introduced in this section as ‘liquidity models’. To do this. it incurs a loss of α. the combination of FRA payoff and hedge entails a net payment of 1. but we neglect these minor details. In the subsequent analysis. 3. while calling the reducedform models in the previous section ‘credit models’. Depositing 1 at time t for a term S + T -t. We consider an institution with insufficient liquidity during a crisis. S + T ) 360 This payoff can be hedged by 1. we shall only consider the first two states. S. . the institution will return to the normal state from the liquidity crisis state. For every dollar it receives for these assets sold into a market in crisis. then at time t. the buyer receives the amount (24) FRAPayoff = d S +T − d S ( 360 f (S.S+T). S ) 360 2. S + T ) − R ). its ability to assume new debt is restricted regardless of whether the FRA 32 Technically. dS − dt 1+ f (t . d − dS 1 + S +T f (S. consider a forward rate agreement. At time S. which is independent of f(S. Without the risk of default or a liquidity crisis. with initial value zero. For this reason.FRAPayoff (one dollar for the loan. If we neglect the impact of illiquidity and credit risk. This effectively leads to a loss equal to α(1 – FRAPayoff) at time S. S. This cash will be unavailable to service debt. S+T) and therefore riskless with value zero. Now. Rolling over this loan minus FRAPayoff at time S. Borrowing the same amount at time t for a term S . the value of R is determined by considering the combination of FRA payoff and hedge. the hedge plus FRA will include additional cash flows that ultimately affect the value of the FRA. we consider again the FRA plus its hedge. We will then assess the impact of the potential occurrence of the second state on the valuation of a FRA.

and multiplying by the bond price. with numeraire equal to the zero coupon bond maturing at S+T. t . dS − dt 1+ f (t . yields an FRA price of (26) − dS d S +T − d S d ( f ( S . S . S + T ) 360 . S ) 360 will reduce the amount it needs to liquidate at S + T. d S − dt 1+ f (t . We prefer to specify the dynamics of X(t) in the risk neutral. t . S + T ) 360 − dt d 1 + S +T f (t . This cash infusion back. after experiencing a liquidity crisis at time S? In this case. the institution either receives or pays a final cash flow. equal to the difference between the deposited funds and the funds to be paid back. S + T ) 360 + (1 + αX ( S + T )) ]. which will now be worth Vdeposit(S+T) = d S − dt 1+ f (t .39 and hedge were executed. however. the institution will therefore gain αVdeposit(S+T). the institution will receive the original deposit − dt d 1 + S +T f (t . as the expectation of the change of numeraire term just factors out if we make an assumption of independence between X(t) and interest rates. as the institution will not need to liquidate assets then. t . t .S. so that it is not dependent on an additional time T. We therefore need to perform a change of numeraire. S + T )) + 360 360 1+ V FRA = − dS d 1 ) E T [−(1 + α ( X ( S ) + X ( S + T ) − X ( S ) X ( S + T )))(1 + R S +T d S +T − d t 360 1+ f (t . S + T ) 360 . At that point. t . this will not affect our answer.S+T) is the value of R for which the expected value of the above quantity (in the T-forward measure) vanishes. however. This amount equals (25) d S +T − d t f (t . S . A final possibility is that there is no liquidity crisis at time S but that the economy is in crisis at time S + T. Summing up these cash flows. S + T ) − R ) − (1 + S +T f ( S . At time S + T. t . S ) 360 The FRA rate f(t. rather than the forward measure. The FRA can be valued most easily in the forward measure. the FRA plus hedge will realize a benefit or incur a loss equal to α times this amount. . Let P(s. t . The cash flows occur at time S+T. What if the economy is in the normal state at time S + T. We shall work with very simple dynamical models of X. S ) 360 which vanishes when R equals the forward rate as computed through traditional arbitrage pricing arguments. there will be no benefit from the deposit that is returned at S + T. This small cash flow will reduce or increase the amount of assets needed to be liquidated at S + T. divided by the numeraire. and will make the further assumption that the dynamics of X and the dynamics of interest rates are independent 33. 33 This assumption is necessary because the expected value of the FRA payoff is taken in the forward measure. and also at time S if a liquidity crisis occurs then.t) denote the risk-neutral probability that X(s) = 1 at time s given that X(t) =0 at an earlier time t ≤s .

Let P(s. M ( s.40 We then have (27) 1 + R d S +T − d S = 360 d S +T − d t f (t . LIBOR quotes will just skyrocket. 34 Bielecki and Rutkowski (2002) show how to perform a change of numeraire (which would lead to a formulation in the risk-neutral measure) in asset pricing models with Markov chain dynamics. t .t) denote the risk-neutral probability that X(s) = 1 at time s given that X(t) =0 at an earlier time t ≤s . . S )) + P( S + T . the probability that it moves from a crisis state into a ‘normal’ state is μ(t). this is not necessary in the liquidity model. t ) ∂P(u . or be removed from the LIBOR panel. t ) 360 . Then P(s. S . The specific liquidity model we have introduced resembles the second credit model introduced in the previous section. assuming that any bank undergoing a liquidity crisis will be unable to borrow funds on the interbank market. with substantial values of α is capable of generating large anomalies. The rationale is the same as discussed with the CIR diffusion credit model. it is unlikely that most of the banks that fund at LIBOR at a given time will be unable to so after a few months. t ) 1 + αP ( S + T . We work in the risk-neutral measure (assuming that we can complete the market and hedge the consequences of changes in X). t ) du. S + T ) 1 + αP ( S + T . t ) ≡ exp( − ∫ (λ ( v ) + µ ( v ))dv ). 1 + α ( P( S . t ) = M ( s. t ) + λ ( s ). The two-state Markov chain liquidity model. S )) We now examine the form of the anomaly with an explicit model for the dynamics of X(t). though individual banks may provide outlying LIBOR quotes. while retaining relatively small transition probabilities (λ) into the illiquid state. S )) f (t . so that λ and μ are riskneutral probabilities 34. S + T ) = α (28) S +T ∫ S ∂P (u . t . t )(1 − P( S + T . S )) + P ( S + T . dS − dt 1 + α ( P ( S . t ) log( ). this has the solution (30) P( s. t s Note that the probability of undergoing a liquidity crisis should remain relatively low for LIBORquoting banks. This is because. ds s if X(0) = 0. if we take this model literally. t ) ∫ t λ (v) M ( v. t )) |u =v ∂u ∂u dv + 1 + α P (v. as does the form of the anomaly. we restricted the state transition probabilities to be constant in time to retain analytic tractability. v) |u =v −(1 − P(v.t) obeys the equation (29) dP = −(λ ( s ) + µ ( s )) P( s. in a crisis. t )(1 − P ( S + T . S ) 1+ 360 This leads to an anomaly ε (see equation 9) equal to 1+ ε (t . Let us assume that X(t) is a simple two-state continuous Markov chain: the probability per unit time that the economy moves into a crisis state is λ(t). instead. In the credit model. a two-state Markov process (entailing normal and risky states) underlies both models. The impact of a transition to the risky state differs in the models. it seems unlikely that nearly the entire LIBOR panel will be replaced.

If the balance sheet of the institution were somewhat stronger. i. this increase in their assets did not matter. Instead. bi-annual and annual floating rate coupons (based on 1. t . These methods require long time series of consistent. the data set is relatively brief (at most two years). Our goal is to fit the term structure of these anomalies. the majority of interest rate swaps have floating rate legs that make quarterly payments proportional with coupons based on 3 month LIBOR. 6 and 12 month LIBOR). to fit the term structure of interest rates. such as Vasicek. quarterly. therefore reducing the amount of illiquid assets that need to be sold at a loss 35. CIR. as their debt capacity was significantly below their outstanding debt. for instance) containing less reliable data. market. S + T ) d S +T − d S (1 − κ )(1 + αP( S + T . t )) 360 (31) 1 + R = ). applied to the calibration to the Vasicek model in Babbs and Nowman (1999) and Maximum Likelihood Estimation.41 In the analysis in this section. with gaps (after the demise of Lehman Brothers. we have assumed that an institution that has entered into the second liquidation state will be unable to borrow any funds at all. equation (27) is replaced with − dt d 1 + S +T f (t . the argument that led to equation (27) must be modified.S. S )) + P( S + T . the debt capacity in (23) would still be below their outstanding debt. (κ + d − dt 1 + α ( P( S . One could assess whether the credit risk models in the previous session produce consistent prices for swaps with monthly. The standard techniques used are Kalman Filtering. it may be the case that the institution in question can borrow some funds. Black-Karasinski. used in the estimation of CIR in Chen and Scott (1993). t . and increases the institution’s debt capacity by a haircut κ multiplied by the value of the deposit. Given the limitations imposed by the data. 3. to be locked in at different times in the future. as we assumed that the institution’s situation was so dire that the would not be able to borrow any funds at all and that with the addition of the asset in the FRA hedge. generally in the context of modeling interest rates.e. and will still have to liquidate assets. The quality and quantity of the FRA data that was available was superior to the data for swaps with non-quarterly floating rate payments. S )) 360 1+ S f (t . and they would still be unable to borrow. The longer-dated deposit that matures at time S+T is an illiquid asset. . anomalies that relate LIBORs spanning various tenors. With this modification. we examine a set of two ratios that characterize the relative sizes of the anomalies for FRAs with underlying rates of different 35 In the argument leading up to (26). or the liquidity crisis less severe. Models can be compared by assessing their fit to time series of asset prices. Fitting Risky LIBOR models to the Term Structure of Anomalies We now turn to assessing whether the credit risk and liquidity models introduced in the previous section can produce satisfactory fits to the anomalies observed earlier in the paper. This endeavor is akin to the analysis of the ability of models of the short rate. we do not pursue a full-blown calibration of these models to a time series of FRA and swap prices. In our case. Under this assumption. There is an extensive literature on calibration of term structure models. In the U. high quality data. S ) 360 10. therefore our analysis in this section is based on FRA data. t )(1 − P( S + T . Two possible sources of market information that determine the anomalies are FRAs and interest rate swaps. but not as much as it requires. as well as the term structure of implied swaption and capfloor volatility.

½).τ ) ≈ K (t . τ ′) + η (t . that (36) η (t . the convexity corrections are small. T .τ ' .τ ). η should be identically zero. . such as (τ′. T + τ ) − ∑ ε (t .2τ ′) ′ τ τ′ τ′ η (t . τ′ 2 η (t . . It is less clear how. T . τ ′) 3 3 3 with τ′ = ¼. In terms of the anomaly ε. we defined the quantity η.42 duration. T . This is akin to adjusting the target rate in the extended Vasicek or CIR models of the short rate to match the term structure of bond prices. the second ratio compares the anomaly between 3 and 6 month LIBOR with the anomaly between 1 and 3 month LIBOR. if the extended CIR or Vasicek models are used to model the stochastic jump intensity. For the jump model. compared to the return on multiple FRAs with shorter underlying rates of tenor τ′. τ ′.τ ' . if the ratio τ / τ′ is held constant. T + iτ ′) .τ ) = ε (t . T . τ ′. With standard arbitrage pricing theory. τ) = (¼ . T . then one can adjust the target rates b(s) to match the anomaly η for different values of T. In section 5. We shall see that the three models that we have introduced make considerably different predictions about the behavior of these ratios. Within this model. τ ′) 2 2 η (t . T . T + . Given a fixed pair (τ′. these models have both the strength and weakness that they make quite rigid predictions of how the anomaly varies with τ′ and τ. It follows. (32) η (t . The ratios that we consider are: (33) χ 2 (T . however. Once one has done this. T + τ′ τ′ . η will behave as τ changes. representing the excess yield obtained on a FRA maturing at time T on a longer underlying rate τ.τ ′. we have .2τ ′) . consider the expression (35) K (t . The first ratio measures the relative size of the anomaly between 12 month and 6 month LIBOR rates with the anomaly between 6 month and 3 month LIBOR rates. τ) . τ ′) ≡ η (t . τ ′) ≡ with τ′ = ½ and (34) χ 3 (T .τ ' . . What behavior do the credit models introduced in the previous section predict for the FRA anomalies and these ratios? The simplest model to analyze is the jump model. i =1 τ τ′ We expect that η will increase with the ratio τ / τ' (the anomaly increases as the two LIBOR rates being compared are further apart in maturity). T .τ ) ≡ τ −1 τ' i =1 ∑ (exp( −v(T + iτ ' ) − exp(−v(T + τ ))) T + iτ ' T + ( i −1)τ ' ∫ exp(vs) E[λ ( s)]. T + (i − 1)τ ′. since as in equation 18. T . τ ′) + η (t . T .

The calculations are based on the solution for the anomaly given in Appendix 1. the curves line up nearly exactly. T . and we find that (39) χ 2 (T . for all three sets.τ ′. given in the first appendix. τ ' ) ≈ exp( − vτ ′ ). the ratio χ3 is close to ¾. τ′ 2 K (t . This behavior is illustrated in Figure 10. T . τ ′) + K (t . The ratio therefore is generally very close to one. τ ′. T + τ′ τ′ . illustrating the fact that these ratios only depend significantly on the jump-size parameter. and nearly independent of the parameters that characterize the diffusion of the jump intensity. τ′ 2 K (t .43 (37) χ 2 (T .2τ ′) .τ ′) = τ′ 2 exp( − τ ′v 2 )(1 − (1 − exp( −τ ′ 2 1 v (1 − exp( )) [ ∫ exp( vs ) E[λ ( s )]ds − 2 2 T +τ ′ 2 T +τ ′ T+ ∫ exp(vs) E[λ ( s)]ds] T T +τ ′ −τ ′ v )) 2 T+ τ' 2 ). T + τ2′ ∫ T exp( vs ) E[λ ( s )]ds + (exp( − τ ′v 2 ) − exp( vτ ′)) ∫ exp( vs ) E [λ ( s )]ds small. T . 2 We have verified that this holds with a high degree of precision with the exact solution with CIR intensity. in which the jump intensity obeys a CIR process. in which these ratios are plotted as a function of ν. τ ′) ≈ K (t . The plot shows this behavior for three very different sets of CIR diffusion model parameters. .000 basis points). τ ′) 2 2 One can re-express the ratio (38) For jump sizes significantly less than one (10. . Even this dependence is mild. . Similarly.τ ′) + K (t . the second term is very K (t . and for very large jump . T + τ′ τ′ 2 2 .2τ ′) . T . in this model. using the credit model with stochastic jump intensity.

the ratios are only modestly below 1 and ¾ respectively. Empirical investigation shows that these ratios are quite insensitive to the value of the jump-size parameter υ.μ) is very close to (typically within .75 (for χ3) when λ and μ are very small to about .λ). The other models do not admit such simple analytic approximations for these ratios.200 bp). The behavior of the anomaly ratios for the two-state Markov chain credit model as a function of λ and μ is illustrated in figures 11 and 12. they are extremely insensitive to the values of other parameters. . one can estimate the range of possible anomaly ratios by looking at just one these two plots. The similarity between the plots in figures 11 and 12 is a consequence of the fact that χ2(λ.μ) is close to χ3(μ.λ) and χ3(λ.02 of) χ2(μ.2 (for χ3) when λ and μ become very large. Figure 10: This figure shows that the ratios between different FRA anomalies decline very slowly with the jump size in the CIR Positive Jump Credit Model.25 (for χ2) and below . As a result of this approximate symmetry.44 sizes (2. These anomaly ratios range from 1 (for χ2) and .

. Figure 12: This figure shows that the ratios between different FRA anomalies decline substantially as μ increases in the two-state Markov chain credit model.45 Figure 11: This figure shows that the ratios between different FRA anomalies decline substantially as λ increases in the two-state Markov chain credit model. Note the similarities between these plots and those in Figure 11.

which determines the rate at which the economy returns to a normal state after a liquidity crisis. the ratios are 1 and ¾ respectively. for different shift functions ξ(t) and mean reversion targets θ and volatilities σ. For small κ. the ratios depend primarily on the strength of mean reversion of this process (κ). near the values predicted by the jump model. but very small. these ratios (based on equations 27-30 with constant λ and μ) are sensitive to the value of μ. but are insensitive to other parameters. Figure 13: This figure shows that the anomaly ratios generated by the Shifted CIR Diffusion Credit Model vary over a wide range as the mean reversion speed changes. dependence on the parameter λ. As κ increases. . In this case. which characterizes the probability of transition into the illiquid state. there is visible. Figure 13 shows this dependence. In the liquidity model. With increasing values of μ these ratios decline towards values of ½ and ⅓. these values decline. these ratios are much larger: 2 and 1. The plot illustrates the behavior in three cases. the dependence on these parameters is so slight that it is not visible on the plots. When the financing spread above LIBOR is modeled as a shifted CIR process.5 respectively. ultimately asymptotically approaching ¼ and ⅛ respectively. An increase of λ by a factor of 10 causes a decrease in the ratio by about 10% when μ is small. in all cases. we shall see that the ratios are primarily sensitive to a single parameter. When it seems like the economy may linger in the illiquid state for a long time.46 In the remaining two models.

a couple of basis points) will lead to substantial error in the estimates of their ratios. they were about 4 basis points for FRAs with 6 and 12 month underlying rates. If one believed that the empirical ratios were too high (or low). We therefore only examine ratios on dates in which our FRA data seems reliable and the anomalies are substantial.g. 10 basis points). The cumulative amount one would pay due to the bid-ask . i. The ratios are relatively insensitive to other parameters. than any significant imprecision in their values (e.g. bid-ask spreads for FRAs with 1 and 3 month underlying rates were typically 2 basis points. If the anomalies are small (e. along with a couple of data points in 2010 during the height of the sovereign debt crisis.e. The anomalies represent the yields of offsetting positions in FRAs. this model admits ratios that are significantly above one. exploiting this would require offsetting positions in a number of FRA contracts based on LIBORs with three different underlying maturities. We note that during this period. This limits us to data during the first half of 2009. Our analysis is restricted by the quality of the data set. so the uncertainty in the value of the anomalies will be larger than the uncertainty in these constituent FRA rates. greater than 20 basis points. We now examine the empirical behavior of these ratios.47 Figure 14: These figures illustrate that in the liquidity model the FRA anomaly ratios vary over a wide range as the rate at which the economy relaxes to its normal state changes.

Note that we have included data on dates in which the anomalies were greater than 20 basis points. The following plots show the behavior of these ratios during portions of 2009 and 2010: Figure 15: The first FRA anomaly ratio. Figure 16: The second FRA anomaly ratio. as observed empirically in 2009 and briefly in 2010. Note that we have included data on dates in which the anomalies were greater than 20 basis points. .48 spreads on these FRAs would preclude exploiting FRA mispricings that are identified via ‘incorrect’ ratios of anomalies. as observed empirically in 2009. unless the observed ratios were extremely far off.

This would only be consistent with parameter values of μ and λ in the two-state Markov chain credit model that are less than one. For the shifted CIR credit model. LIBOR basis swaps of varying maturities. the empirical data is consistent with a value of μ that is much larger than one. Our regression results show that these anomalies track the LIBOR – OIS spread. It appears that these ratios. On the other hand. the ratios were considerably larger. closer to the peak of the credit crisis. This model then effectively predicts that a LIBOR-based bank is likely to have its funding costs rise significantly above LIBOR within a year. indicating that for the liquidity model. The two-state Markov chain credit model and liquidity model both are compatible with the observed term structure ratios.g. this seems implausible. we do not observe ratios greater than one. the ratios are consistent with higher values of μ and λ in the two-state Markov chain credit model. deviations of 0. with plausible albeit very different parameter values. somewhat close to the values implied by the positive jump credit model and the maximum allowable ratios admitted by the shifted CIR diffusion credit model and two-state Markov chain credit model. these occur for smaller values of the parameter μ. corresponding to an illiquid state that is likely to persist for more than a year. from May through July of 2009. and would only occur if most of the banks within the LIBOR panel were replaced within a year. for much of 2009. through bootstrapping. a few months. the ratio χ2 was typically greater than 0. earlier in 2009. indicating that though a transition to the ‘bad’ credit state was unlikely. albeit with calibrations that require different parameter values (mean reversion speed κ for the shifted CIR credit model and relaxation time μ for the liquidity model) at different dates. relative to each other and to bank LIBOR quotes. The anomalies can potentially be hedged through . With the exception of a few outlying data points. e. The liquidity model has a distinct practical advantage. The other three models admit solutions that are compatible with the ratios. This provides a great deal of flexibility in fitting the model to market data. It seems unlikely that simple analytical solutions can be found for the anomaly in the two-state Markov chain credit model if λ and μ are allowed to vary with time. It is clear that the positive jump credit model does not generally provide a good fit to the FRA term structure. In the late spring and summer of 2009. the values of κ compatible with the ratios are generally larger than one. that the model predicted that once there.49 Given the imprecision in FRA rates. In contrast. the typical duration of the illiquid state is short – at most. were not so far from the lower limits obtained from the liquidity model for very large values of μ. As pointed out earlier.8. Their presence means that interest rate modeling has become more complex since the advent of the credit crisis. Conclusion We define and observe time series of anomalies in the pricing of Forward Rate Agreements and Eurodollar Futures contracts.1 or so in these ratios are not significant. Generally. 11. These anomalies are substantial from August 2007 until present. a financial institution was likely to remain in that state for more than a year. traditional methods of bootstrapping yield curves no longer work. The liquidity model is the only model that permits ratios significantly greater than one. It admits relatively simple analytical solutions when the Markov transition probabilities λ and μ are allowed to be piecewise constant functions of time.

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.” Journal of Applied Probability 8 (1971). G. Appendix I: In this appendix. J. ∫ s T We simplify this by noting that the probability density for the occurrence of k jumps at times t1. Simple Statistics and Facts Before and During the Credit Crisis.” Journal of Financial and Quantitative Analysis 26 (1991). The anomaly that we will calculate is given by the expression: (3) ε (λ0 .” Working Paper (2010).” New York Times (September 30. 2008). “Funding beyond Discounting: Collateral Agreements and Derivative Pricing. Expressions for the anomaly can be derived when the stochastic intensity obeys an extended Vasicek-type diffusion: (1) dλ = a (b( s ) − λ )ds +σdW as well as an extended Cox-Ingersoll-Ross diffusion: (2) dλ = a (b( s ) − λ )ds +σ λ dW .” Risk Magazine (2010). s. P. T ) = − log( E * [exp( − ϕ ( s. Sundaresan. 381-390. J. t1 )ds | λ (t ) = λ0 )]) (T > s ≥ t ) . … tk between s and T is . Financial Engineering 15 (2007). V. M (ed). “Incomplete Markets. S. “Mind the Gap: Disentangling Credit and Liquidity in Risk Spreads. and Gabbi. we derive the formulas for the anomaly given that the credit deterioration process R(s. Politi.54 “Bank Lending Seizes Up Worldwide.t) – ls = φ(s. “Interest Rate Models with Multiple Yield Curves. 409424.” Risk Books (2005).” Handbook in Operations Research and Management Science.. Forward Prices.” Working Paper (2009). G. G.. 97-102. K.. M. “Futures prices on Yields. Pallavicini.t) is characterized by a jump process with jump size ν and stochastic intensity λ. “Occupation Times for Two State Markov Chains. and Tarenghi. Staum.” Working Paper (2010).. t. Pykhtin. A. and Implied Forward Prices from Term Structure. Germano. Iori. Piterbarg. 511-563. M. Schwarz. “Counterparty Credit Modelling: Risk Management. “The Overnight Interbank Market. Pedler. Pricing and Regulation.

t ) 2 ∂q0 2 ∂t ∂q0 P ( q0 . T ) ≡ 1 − exp(v(u − T ). T ) = − log( E * [exp(− ∫ h(u . T ). ε (λ0 . t .. β ≡ 2 v (12) a w( z ) ≡ z −m u( z ).T) such that (11) ∂ ln u (t ) σ2 σ2 hu = 0. T ) q0 − B (t . T ) ≡ h(u . T ) = − log( E * [∑ dt1 dt 2 . then dq = f ( q.. This is apparent if the following changes of variables are applied: 2σ v (T − t ) ). T ) A(t .T). then this expression can be computed via a change of variables and application of the Feynman-Kac theorem. u )dW . T ) = E * [exp( − ∫ q(u. t ... first defining q (u . dt k p (t1 . t. h(t . ∫ ∫ ∫ k =1 s s s i =1 k This expression simplifies to (6) ε (λ 0 . T ). This equation is solved for P in the affine form: (10) ∂B = − ab(t )h(t .55 (4) p (t1 . we work with the CIR model in the remainder of this appendix. T )) t T is the solution of the partial differential equation (9) ∂2P ∂P 1 2 2 ∂P + σ g ( q0 . T ) ∂A )A − − (a − A = 1. (7) ∂ ln h(u. When the diffusion for λ is given by the Vasicek or CIR model. P( q0 . which can be solved by defining u(t. s T We will first derive an expression for the quantity ε(λ0. T )λ (u ) .t. u ) ≡ h(u. 2 ∂t ∂t The equation for A is a Riccati equation. T ) A(t . T ) = − log( P (λ0 h (t . h(u . In particular. s. T ). T ) = exp( − A(t .. v z ≡ β exp( − The function w satisfies the Bessel equation . s.. u )du + σg ( q. + f ( q0 . g ( q. T ) = 1. T )du ) | q(t ) = q0 ] . We can then write (5) ε (λ 0 . t. t . t k ) exp( −v ( kT − ∑ t i ) | λ (t ) = λ 0 ]) .t.. t k ) = ∏ λ (t ) exp( − ∫ λ (u)du) i =1 i s k T k! ∞ T T T . T ) f ( q. T . u ) ≡ ab(u )h(u ) + ( − a + ) q... T )). t . t ) = q0 P. T ) q . t . ∂t σ 2 h (t . u"−au'− ≡− 2 2 ∂t The solution for u can be expressed in terms of Bessel functions of the first kind. T )λ (u )du ) | λ (t ) = λ 0 ]). T ) 2 ∂ ln h(t . m ≡ . ∂u The Feynman-Kac theorem implies that the quantity (8) P ( q0 .

α ≡ β 2 + m2 . T )du) | q( s. The final expression depends on the Laplace transform of the Cox-Ingersoll-Ross transition density.T) is (16) B(t . T ) A(t . T )] = s T exp( − B( s. Working backwards. 2v (15) 1 J ' v ( z ) = ( J v −1 ( z ) − J v +1 ( z )).T) is obtained by integrating the product of ab(t) and h(t.56 (13) z 2 w"+ zw'+( z 2 − α 2 ) w = 0. To derive formulas for the more general expression ε(λ0. J α ( β ) + ΓJ −α ( β ) With A and B.T) = 0 and defining τ≡T-t. 2 J v ( z) = B(t. b(t) = b. T ) = λ1h( s.T)A(t.t. When the target rate. This is well-known (see Cox.T). T )λ1 )). T )h( s. then .T) we begin with E * [exp( − ∫ q(u. T )] = s T (17) ∫ dλ1 p(λ ( s) = λ1 | λ (t ) = λ0 ) E * [exp( − ∫ q(u.s. we find that (14) h(t . T ) = − a + a + 2σ 2 2 σ 2 − 2 σ exp( − vτ ) 2 − J α +1 ( β exp( − vτ vτ ) + ΓJ −α −1 ( β exp( − )) 2 2 . T ) − ∫ dλ1 p(λ ( s ) = λ1 | λ (t ) = λ0 ) exp( − A( s. when the function b(t) is piecewise constant B(t. we have a precise expression for ε(λ0. To derive this equation. Jα is the Bessel function of the first kind of order α. applying the boundary condition that A(T. the expression for B(t.T). Ingersoll and Ross (1985) or Cairns (2004) and can be derived using a variant of the Feynman-Kac theorem. T ) = λ0 h(t . a + a 2 + 2σ 2 J −α ( β ) + J −α −1 ( β ) 2σ J α +1 ( β ) − z ( J v −1 ( z ) + J v +1 ( z )).t. With b(t) = b.t. T )du ) | q(t . vτ vτ J α ( β exp( − ) + ΓJ −α ( β exp( − )) 2 2 In the above equation. T ) = − a bτ 2 σ 2 + 2ab J α ( β exp( − ln( σ2 vτ vτ )) + ΓJ −α ( β exp( − )) 2 2 ). we use the relationships between Bessel functions: a + a 2 + 2σ 2 J α (β ) 2σ Γ≡ .T) can be expressed in terms of logarithms of linear combinations of Bessel functions .

when the parameters α and β become very large. rather than a rigorous proof. 2a 2 (σ + ) exp( a ( s − t )) − σ k 2ab 2a ). These bounds hold regardless of whether LIBOR is a refreshed rate. T )h ( s. t . as our demonstration depends on assumptions about the sign of certain covariance terms that are reasonable. Combining the above expressions. One can also run into trouble numerically evaluating limiting cases of these expressions. This expression is relatively straightforward to code into any library (e. one may have to use asymptotic expansions for Bessel functions to arrive at expressions for the anomaly. t t1 t1 t2 This inequality is plausible. without taking the limit for the numerator and denominator separately. this was not necessary. T ). the solution can be expressed as linear combinations of Bessel functions of the first and second kind. As in the body of the paper: r denotes the risk-free rate. but LIBOR is not modeled as a refreshed rate. t. It follow that Γ=(-1)α+1 and the numerator and denominators in the latter part of the expression for hA are both zero. We use the RMV framework and exploit the fact that observed discrepancies between rates inferred from Eurodollar futures and FRAs are very small. s ) = . t . s )λ0 h (t . however. D ( k . For the parameter values that we used in this study. T ) = B ( s. l denotes the instantaneous rate at which a bank that pays LIBOR can borrow and R(u. s ).57 ∫ dλ p(λ ( s) = λ 1 1 | λ (t ) = λ0 ) exp( −kλ1 )) = exp( −C ( k . . T ) + D ( A( s. The first problem occurs on a parameter set of measure zero: when α is an integer. s )λ0 − D ( k . since lower risk-free rates at time t1 are more likely to accompany higher risky bond prices at t1. but could possibly be violated in a model with particularly unusual and artificial dynamics. t . t . There are two potential difficulties in doing this. Appendix II: We argue in this appendix that the observed FRA-cash anomaly cannot be explained by a simple credit model in which bank-lending is credit risky. T ). t . or equivalently. T ) + C ( A( s. We begin by deriving bounds on particular covariance terms in terms of the Eurodollar futures – FRA basis. 2a (18) C ( k . the limit as α approaches an integer value can be computed. They are predicated on the following assumption: (1) cov[exp( − ∫ rs ds ). In these cases. Matlab) that includes routines for evaluation of Bessel functions. In this case. t . Jα(z) = (-1)αJ-α(z). s )). exp( − ∫ R ( s.e. T )h( s. t1 )ds )] ≥ 0. We present a plausibility argument. we find the anomaly equals (19) ε (λ0 . s.g. s ) = − 2 ln( 2 σ σ k (1 − exp( −a ( s − t ))) + 2a 2 The extension of the above expressions to piecewise constant forms of b(t) is straightforward. In this case. t) denotes the instantaneous rate paid at time u by a bank that paid LIBOR at time t. i.

exp( − ∫ R( s. E * [exp( − ∫ rs ds )] t 2 2 1 log(1 − cov[exp(− ∫ R ( s. let us examine the expression for the FRA – cash LIBOR basis. It then follows that cov[exp( − ∫ R( s. Given this. then the difference between the yield inferred from a Eurodollar futures contract maturing at time t1 on a rate of tenor t2 – t1. it reduces to the much-studied convexity correction applied to Eurodollar futures prices.58 The standard formula for valuation of Eurodollar contracts still holds in the case in which LIBOR is risky 36. t1 . exp( ∫ R ( s. t1 t1 t2 t2 (4) cov[exp( − ∫ rs ds ). t1 )ds )] t t1 t1 t2 E * [exp( ∫ R( s. this basis is 36 We assume that the risk of default on the Eurodollar futures contract can be neglected (a reasonable assumption. In this case. 37 Even if the second covariance term is negative. t 2 ) Note that the expression for δ does not vanish even if the risk-free and risky rates are the same. t1 )ds )] t1 t2 E * [exp( − ∫ rs ds )] t t1 ) The first covariance in the above expression is negative (this follows from Jensen’s inequality). exp( − ∫ R ( s. exp( ∫ R( s. t 2 ) = t 2 − t1 t1 t1 t t (3) cov[exp(− ∫ rs ds ). the futures rate equals the expected value of LIBOR in the risk-neutral measure. and the corresponding FRA rate is: (2) 1 δ EDFut − FRA (t . t1 . t 2 ) = log( t 2 − t1 This can be re-expressed as E * [exp( − ∫ rs ds ) E * [exp( − ∫ R( s. t1 )ds )] t1 t2 E * [exp( − ∫ rs ds )] t t1 ≤ (t 2 − t1 )δ FRA− EDFut (t . relating covariance terms to the futures-forward basis. t 2 ). t1 )ds ). t1 . as in Grinblatt and Jegadeesh (1995). t1 )ds ). In this case. If. as above. t1 )ds )]]E * [exp( ∫ R( s. t1 )ds )] t t1 t1 t2 E * [exp( ∫ R ( s. i.e. If we express all rates using continuous compounding. it would be implausible that the covariance terms would be large (more than a few basis points). We have assumed that the second covariance term is positive. as they would have to cancel each other very precisely to leave only a small residual difference between yields inferred from FRAs and yields from Eurodollar futures. t1 )ds )] ≤ (t 2 − t1 )δ FRA− EDFut (t . the rates are expressed using continuous compounding. given that it is traded on an exchange). t1 )ds )] t t1 t1 t1 t1 t2 t2 ) . t1 . both terms containing covariances have the same sign 37. . t1 )ds )] + δ EDFut − FRA (t . the discrepancy between forward rates inferred from FRAs and rates inferred from the current values of LIBOR.

t 2 ) ≤ t 2 − t1 ≤ (t 2 − t1 )δ FRA− EDFut (t . exp( − ∫ l s ds )) t t2 t1 t1 t2 ). t1 )ds )]]E * [exp( − ∫ R ( s. t1 . t 2 ) = 1 log(1 + t 2 − t1 t1 E * [exp( ∫ l s ds )] cov(exp( − ∫ rs ds ). exp( − ∫ l s ds )) t t1 t2 t1 t1 t t1 t2 t2 t1 − cov(exp( − ∫ l s ds ). t1 .e. E * [exp( − ∫ l s ds )]E * [exp( − ∫ rs ds )] t t E * [exp( − ∫ l s ds )] t Substituting in the inequalities derived above. the expression above can be manipulated into the form (6) δ CashLIBOR − FRA (t . t 2 ) cov(exp( ∫ l s ds ). t1 . t 2 ) E * [exp( ∫ l s ds )] t1 t2 + − (t 2 − t1 )δ FRA− EDFut (t . t 2 ) = (5) 1 log( t 2 − t1 E * [exp( − ∫ rs ds ) E * [exp( − ∫ R ( s. t1 . t1 . during the credit crisis it was large and positive. exp( − ∫ l s ds )) cov(exp( ∫ l s ds ). t1 . exp( − ∫ l s ds )) t1 t t2 t2 t1 E * [exp( − ∫ l s ds )]E * [exp( ∫ l s ds )] t t1 38 t2 − cov(exp( − ∫ l s ds ).59 δ CashLIBOR − FRA (t . exp( − ∫ l s ds )) t t1 t1 t1 t1 E * [exp( − ∫ rs ds )] t − cov(exp( − ∫ rs ds ). t) = ls represents the instantaneous rate of borrowing of all ‘LIBOR-banks’ and is independent of t. we have 38 (7) exp((t 2 − t1 )δ CashLIBOR − FRA (t . t )ds )] t t1 t1 t t2 t1 t2 t1 ). E * [exp( − ∫ l s ds )] t The first inequality assumes that the cash LIBOR – FRA spread is positive. t )ds )] t t Now let us assume that LIBOR is not modeled as a refreshed rate. t 2 )) − 1 δ CashLIBOR − FRA (t . so that all institutions that can borrow at LIBOR at a time t will be able to borrow at LIBOR at a later time s>t. t 2 ) + (t 2 − t1 ) 2 δ 2 FRA− EDFut (t . exp( − ∫ l s ds )) t1 t1 t t1 t2 t1 t2 + E * [exp( − ∫ rs ds )] t t2 t2 t2 cov(exp( − ∫ rs ds ). t1 . R(s. exp( − ∫ l s ds )) t t2 t1 t1 t2 ). . In this case. exp( − ∫ l s ds )) cov(exp( ∫ l s ds ). E * [exp( − ∫ rs ds )]E * [exp( − ∫ R ( s. i.

at least within this modeling framework.60 In our observations. 39 The covariance in the fourth term as well is unlikely to be an order of magnitude larger than t2 t2 cov(exp( ∫ ls ds ). With a 3 month underlying Eurodollar futures rate. t1 t1 . the first and third terms on the right hand side are exactly or approximately equal to one-fourth of the FRA-Eurodollar Futures spread. These results are not consistent with the above equation. that LIBOR must be treated as a refreshed rate to explain the FRA – cash LIBOR spread. rather than add to the cash LIBOR – FRA spread. 39 It therefore follows. The covariance in the fourth term is likely to be positive. the cash LIBOR – FRA spread exceeded 100 basis points and during the height of the crisis was well over a factor of 10 greater than the FRA – Eurodollar Futures spread. exp( − ∫ ls ds )) . so this term should likely reduce. which we have argued is bounded by the Eurodollar – Futures spread. The second term is far smaller.

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