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

40 Pages Posted: 27 Jun 2019 Last revised: 8 Mar 2021

See all articles by Alex Backwell

Alex Backwell

University of Cape Town

Andrea Macrina

University College London; University of Cape Town (UCT)

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)

David Skovmand

University of Copenhagen

Date Written: June 5, 2019

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,

Suggested Citation

Backwell, Alex and Macrina, Andrea and Schloegl, Erik and Skovmand, David, Term Rates, Multicurve Term Structures and Overnight Rate Benchmarks: a Roll-Over Risk Approach (June 5, 2019). Available at SSRN: https://ssrn.com/abstract=3399680 or http://dx.doi.org/10.2139/ssrn.3399680

Alex Backwell

University of Cape Town ( email )

University of Cape Town
Rondebosch
Cape Town, Western Cape 7700
South Africa

Andrea Macrina (Contact Author)

University College London ( email )

Gower Street
London, WC1E 6BT
United Kingdom

University of Cape Town (UCT) ( email )

Private Bag X3
Rondebosch, Western Cape 7701
South Africa

Erik Schloegl

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

David Skovmand

University of Copenhagen ( email )

Nørregade 10
Copenhagen, København DK-1165
Denmark

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