Interest Rate Swaps: A Comparison of Compounded Daily Versus Discrete Reference Rates
27 Pages Posted: 10 May 2021 Last revised: 7 Sep 2021
Date Written: May 7, 2021
This paper studies the hedging effectiveness of interest rate swaps using different reference rates for eliminating interest rate risk from floating rate loans. Two different reference rates are studied. The first is a reference rate whose maturity, ∆, matches the payment interval of the floating rate loan. The second is a reference rate whose maturity is ∆/N. The prime examples are LIBOR and SOFR, respectively. We show that the ∆-based interest rate swap provides a good static hedge, but the ∆/N-based swap does not. Although dynamic hedging with the ∆-based interest rate swap is possible under some conditions, it both introduces model risk and increases transaction costs, making it a less practical alternative.
Keywords: Interest Rate Swaps, LIBOR, SOFR, Floating Rate Loans
JEL Classification: E43, G12, G13, G21
Suggested Citation: Suggested Citation