A Consistent Framework for Modelling Basis Spreads in Tenor Swaps

54 Pages Posted: 8 May 2014 Last revised: 16 Jan 2015

See all articles by Yang Chang

Yang Chang

School of Risk and Actuarial Studies, ARC Center of Excellence in Population Ageing Research (CEPAR); Quantitative Finance Research Centre

Erik Schlögl

University of Technology Sydney (UTS), Quantitative Finance Research Centre; University of Cape Town (UCT) - The African Institute of Financial Markets and Risk Management; Faculty of Science, Department of Statistics, University of Johannesburg; Financial Research Network (FIRN)

Date Written: January 15, 2015

Abstract

The phenomenon of the frequency basis (i.e. a spread applied to one leg of a swap to exchange one floating interest rate for another of a di fferent tenor in the same currency) contradicts textbook no-arbitrage conditions and has become an important feature of interest rate markets since the beginning of the Global Financial Crisis (GFC) in 2008. Empirically, the basis spread cannot be explained by transaction costs alone, and therefore must be due to a new perception by the market of risks involved in the execution of textbook "arbitrage" strategies. This has led practitioners to adopt a pragmatic "multi-curve" approach to interest rate modelling, which leads to a proliferation of term structures, one for each tenor. We take a more fundamental approach and explicitly model liquidity risk as the driver of basis spreads, reducing the dimensionality of the market for the frequency basis from observed spread term structures for every frequency pair down to term structures of two factors characterising liquidity risk. To this end, we use an intensity model to describe the arrival time of (possibly stochastic) liquidity shocks with a Cox Process. The model parameters are calibrated to quoted market data on basis spreads, and the improving stability of the calibration suggests that the basis swap market has matured since the turmoil of the GFC.

Keywords: tenor swap, basis, frequency basis, liquidity risk, swap market

JEL Classification: C6, C63, G1, G13

Suggested Citation

Chang, Yang and Schloegl, Erik, A Consistent Framework for Modelling Basis Spreads in Tenor Swaps (January 15, 2015). Available at SSRN: https://ssrn.com/abstract=2433829 or http://dx.doi.org/10.2139/ssrn.2433829

Yang Chang

School of Risk and Actuarial Studies, ARC Center of Excellence in Population Ageing Research (CEPAR) ( email )

Australian School of Business Building
University of New South Wales
Sydney, New South Wales NSW 2052
Australia

Quantitative Finance Research Centre ( email )

University of Technology, Sydney
Sydney, New South Wales 2000
Australia

Erik Schloegl (Contact Author)

University of Technology Sydney (UTS), Quantitative Finance Research Centre ( email )

Ultimo
PO Box 123
Sydney, NSW 2007
Australia
+61 2 9514 2535 (Phone)

HOME PAGE: http://www.schlogl.com

University of Cape Town (UCT) - The African Institute of Financial Markets and Risk Management ( email )

Leslie Commerce Building
Rondebosch
Cape Town, Western Cape 7700
South Africa

Faculty of Science, Department of Statistics, University of Johannesburg ( email )

Auckland Park, 2006
South Africa

Financial Research Network (FIRN)

C/- University of Queensland Business School
St Lucia, 4071 Brisbane
Queensland
Australia

HOME PAGE: http://www.firn.org.au

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