Interest Rate Swaps: A Comparison of Compounded Daily Versus Discrete Reference Rates

27 Pages Posted: 10 May 2021 Last revised: 13 May 2021

See all articles by Robert Jarrow

Robert Jarrow

Cornell SC Johnson College of Business

Siguang Li

Cornell University, Dept. of Economics

Date Written: May 7, 2021

Abstract

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

Jarrow, Robert and Li, Siguang, Interest Rate Swaps: A Comparison of Compounded Daily Versus Discrete Reference Rates (May 7, 2021). Available at SSRN: https://ssrn.com/abstract=3841313 or http://dx.doi.org/10.2139/ssrn.3841313

Robert Jarrow

Cornell SC Johnson College of Business

Ithaca, NY 14850
United States

Siguang Li (Contact Author)

Cornell University, Dept. of Economics ( email )

404 Uris Hall
Ithaca, NY Tompkins 14853
United States

HOME PAGE: http://www.siguangli.com

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