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On the White Board - November 2009
Nov 15, 2009
LIBOR Market Dislocation - Segmenting the Swap Curve
The financial crisis has swept away trillions of dollars and called into question many commonly held principles. “Dislocation" is a term often used in various market sectors. For example, the construction of a LIBOR curve has been affected by this turmoil. It has been customary to combine the outright interbank deposit rates, interest rate futures and interest rate swaps for the short-, middle-, and long-term sections of the LIBOR swap curve. These financial securities all have LIBOR rates as their underlying price driver. For some terms, LIBOR rates are collected and posted by institutes such as BBA. For other terms, the rates are embedded in the prices of derivatives. The fact that multiple derivatives reference a common underlier allows for the construction of a complete, consistent, and smooth yield curve.
Farewell to the good old times. Starting from 2007, there were concerns that BBA-quoted LIBOR rates might have deviated from the actual bank deposit rates; swap rates based on different LIBOR rates, i.e., 1M versus 3M, started to exhibit a non-negligible basis. There are a number of possible explanations for this basis, ranging from credit risk to the inability or unwillingness of banks to arbitrage away the difference due to liquidity constraints.
Figure 1: LIBOR based security rates before, during, and after the ?nancial crisis.
All these result in the new practice of using multiple LIBOR swap curves wherever things are no longer compatible with each other. How this segmentation of the LIBOR swap curve should propagate into derivative pricing is yet to be thoroughly studied and standardized.