Term Rates, Multicurve Term Structures and Overnight Rate Benchmarks: a Roll-Over Risk Approach

Abstract

In the current LIBOR transition to overnight-rate benchmarks, it is important to understand theoretically and empirically what distinguishes actual term rates from overnight benchmarks or ``synthetic'' term rates based on such benchmarks. The well-known ``multi-curve'' phenomenon of tenor basis spreads between term structures associated with different payment frequencies provides key information on this distinction. This information can be extracted using a modelling framework based on the concept of ``roll-over risk'', i.e., the risk a borrower faces of not being able to refinance a loan at (or at a known spread to) a market benchmark rate. Separating the roll-over risk priced by tenor basis spreads into a credit-downgrade and a funding-liquidity component, the theoretical modelling and the empirical evidence show that proper term rates based on the new benchmarks remain elusive and that a multi-curve environment will persist even for rates secured by repurchase agreements.

Keywords: Roll-Over Risk, Multi-Curve Interest Rate Term Structure, OIS, IBOR, LIBOR Transition, Basis Swaps, Calibration

JEL Classification: C02, G12,