The Zeeman Effect in Finance: Libor Spectroscopy and Basis Risk Management
22 Pages Posted: 31 Oct 2011 Last revised: 29 Oct 2012
Date Written: October 31, 2011
Once upon a time there was a classical financial world in which all the Libors were equal. Standard textbooks taught that simple relations held, such that, for example, a 6 months Libor Deposit was replicable with a 3 months Libor Deposits plus a 3x6 months Forward Rate Agreement (FRA); that floating rate notes were worth par, and that Libor was a good proxy for the risk free rate required as basic building block of no-arbitrage pricing theory.
Nowadays, in the modern financial world after the credit crunch, some Libors are more equal than others, depending on their rate tenor, and the classical relations above have become history. Banks are not anymore “too big to fail”, Libors are fixed by panels of risky banks, hence they are risky rates themselves.
These simple empirical facts carry very important consequences in derivative’s trading and risk management, such as, for example, the questions of basis risk and of so-called “CSA-discounting”; something that should be carefully considered by anyone managing even a single plain vanilla Swap.
In this qualitative note we review the problem trying to shed some light on this modern animal farm, recurring to a nice analogy with quantum physics, the Zeeman’s effect.
Keywords: crisis, liquidity, credit, counterparty, risk, fixed income, Libor, Euribor, Eonia, yield curve, forward curve, discount curve, single curve, multiple curve, collateral, CSA- discounting, liquidity, funding, no arbitrage, pricing, interest rate derivatives, Deposit, FRA, Swap, OIS, Basis Swap
JEL Classification: E43, G12, G13
Suggested Citation: Suggested Citation