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

Abstract

Modelling the risk that a financial institution may not be able to roll over its debt at the market reference rate, the so–called “roll–over risk”, we construct a model framework for the dynamics of reference term rates (e.g., LIBOR) and their spread vis–à–vis benchmarks based on overnight reference rates, e.g., rates implied by overnight index swaps (OIS). In this framework, different interest rate term structures are endogenously generated for each tenor, that is, a different term structure for each choice of the length of the interest rate accrual period, be it overnight (e.g., OIS), three–month LIBOR, six–month LIBOR, etc. A concrete model instance in this framework can be calibrated simultaneously to available market instruments at a particular point in time, but more importantly, we explicitly obtain dynamics of term rates such as LIBOR. Thus models in our framework are amenable to econometric estimation. For a model class based on affine dynamics, we conduct an empirical analysis on EUR data for OIS, interest–rate swaps, basis swaps and credit default swaps. Our model achieves a better fit to time series data than other models proposed in prior literature. We find that credit risk typically contributes only about 30% of the IBOR/OIS spread, with the balance of the spread due to the funding liquidity component of roll–over risk. Looking ahead, we show that, even if credit risk is entirely mitigated by repo transactions, the presence of roll–over risk confounds attempts to obtain term rates from overnight rate benchmarks. As various jurisdictions transition away from panel–based term rate benchmarks towards transaction–based overnight ones (such as SOFR in the United States), the framework presented in this paper thus provides important insights into some of the consequences of this transition.

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

JEL Classification: C02, G12,