Implications of Implicit Credit Spread Volatilities on Interest Rate Modelling

European Journal of Operational Research, Forthcoming

37 Pages Posted: 11 Apr 2017 Last revised: 4 Jun 2017

Date Written: April 10, 2017

Abstract

We test seven term structure models in the Heath-Jarrow-Morton (1992) class in order to find the best representation of the Libor rate in interest rate markets after the credit crunch of 2007. The Libor rate is considered as a risky rate, subject to the credit risk of a generic counterparty whose credit quality is refreshed at each fixing date. We study the volatilities of the credit spreads implicitly obtained from Libor time series. In order to understand how assumed volatility functions affect interest rate curve modelling and asset pricing, we develop a model to estimate basis swap prices through the Monte Carlo simulations. We compare obtained results and individuate systematic relations existing between the basis spread forecast error and both the accuracy in volatility modelling and the accuracy of the Monte Carlo method. We analyze and document these relations by defining appropriate pricing error measures.

Keywords: Finance; Arbitrage-free models; Libor; Term structure; Volatility modelling

Suggested Citation

Fanelli, Viviana, Implications of Implicit Credit Spread Volatilities on Interest Rate Modelling (April 10, 2017). European Journal of Operational Research, Forthcoming. Available at SSRN: https://ssrn.com/abstract=2949703 or http://dx.doi.org/10.2139/ssrn.2949703

Viviana Fanelli (Contact Author)

University of Bari ( email )

Piazza Umberto I
Bari, 70028
Italy

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