Interest Rate Curves before and after the crisis

Raffaele Giura
Banca IMI - Risk Trading Fixed Income raffaele.giura@bancaimi.com

Raffaele Giura Interest rate yield curves before and after the crisis

One of the first notions in finance textbooks..

..is that investing at the 6m spot rate

should be equivalent to

investing at the 3m spot rate

and reinvesting the proceeds at the 3X6 forward rate.. ..otherwise arbitrage opportunities can exist in the market place

Raffaele Giura Interest rate yield curves before and after the crisis

..which implies that..

..if you have to compute the 6m discount factor you can compute it using the 6m spot rate; or the 3m spot rate and the 3X6m forward rate; or the 1m spot rate, the 1X2 forward rate, the 2X3 forward rate...

Rates 0X1 1X2 2x3 3x4 4x5 5x6

Rates

0X3

3X6

Rate

0X6

Raffaele Giura Interest rate yield curves before and after the crisis

A typical pre-crisis Euribor curve building framework

Market Instruments: Deposits Euribor futures I.R.S. Pricing: I.R.S. F.R.A ..Others.. Interpolation Bootstrapping Market Tenors Disc. Factors

Raffaele Giura Interest rate yield curves before and after the crisis

Example: 3X6 F.R.A. pricing pre-crisis

3m d.factor Pricing F.R.A. 3X6 6m d.factor

3m depo (euribor) 6m depo (euribor)

Raffaele Giura Interest rate yield curves before and after the crisis

The single currency basis swap:

Even before the crises in the market investing at the 6m euribor spot rate was not equivalent to investing at the 3m euribor spot rate and reinvesting the proceeds at the 3X6 euribor forward rate
Not= +

3X6 F.R.A. in the market was not actually priced from the 3m and 6m Euribors This difference was explicitely priced in the single currency basis swap market

Raffaele Giura Interest rate yield curves before and after the crisis

If before the crisis the 3m-6m basis was small..

Market prices of the 3m vs 6m euribor basis swap for the 1y and 10y maturities: 2004 - 2007

Raffaele Giura Interest rate yield curves before and after the crisis

..after the crises you can not ignore it anymore

Market prices of the 3m vs 6m euribor basis swap for the 1y and 10y maturities: 2006 - 2010

Raffaele Giura Interest rate yield curves before and after the crisis

The old framework performance after the crisis

Euribor 6m fwd
4 3.5 3 2.5 2 1.5 7-Jan-11 26-Jul-11 11-Feb-12 29-Aug-12 17-Mar-13 3-Oct-13 21-Apr-14

Pre-crisis framework

Correct mkt data

Raffaele Giura Interest rate yield curves before and after the crisis

New curve building framework

Forwarding curves

Used only for computing the forward fixings implied in the market. Made from instruments with homogeneous underlying fixing

Discounting curves

Used only for cashflow discounting

Raffaele Giura Interest rate yield curves before and after the crisis

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Forward fixing curve

Euribor 3M Fwd

3.3000 2.8000 2.3000 1.8000 1.3000 0.8000

17-May- 25-Aug- 3-Dec- 13-Mar- 21-Jun- 29-Sep- 7-Jan- 17-Apr- 26-Jul2009 2009 2009 2010 2010 2010 2011 2011 2011 3-Nov- 11-Feb2011 2012

Raffaele Giura Interest rate yield curves before and after the crisis

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Swap floating leg pricing

Euribor 3M Fwd

3.3000 2.8000 2.3000 1.8000 1.3000 0.8000 17-May2009

3-Dec-2009

21-Jun2010

7-Jan-2011 26-Jul-2011

11-Feb2012

Fixing Date 3-Jul-09 5-Oct-09 5-Jan-10 1-Apr-10

Start Date 7-Jul-09 7-Oct-09 7-Jan-10 7-Apr-10

End Date 7-Oct-09 7-Jan-10 7-Apr-10 7-Jul-10

Fixing Rate 1.0636 1.0408 1.0315 1.2127

Payment Date 7-Oct-09 7-Jan-10 7-Apr-10 7-Jul-10

Cash Flow 271,809 265,982 257,875 306,544

Discount 0.9986 0.9969 0.9950 0.9926

Cash Flow NPV 271,430 265,154 256,582 304,270

Float Leg NPV =

1,097,436

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How can we practically build forwarding curves? Direct solution..

Euribor instruments

Discount factors

Forward fixings

We start from a set of market instrument with the same underlying euribor fixing We directly convert them in a discount factors We will compute the forward fixings we need from these discount factors It looks similar to the pre-crisis framework but it is more complex..

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Lets compute the forwarding curve discount factors

0X3 0X3 3X6 6X9 9X12 .......

3m Euribor market data set

3X6

F.R.A.

6X9 disc. 3m 9X12 ........ 6m 9m 12m .....

0X6

0X6

6X12

.......

6m Euribor market data set

6X12

F.R.A.
12X18 disc. 6m 12m .....

........

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Problem: how do we compute the in-between discount factors now?

F.R.A.

0X6

6X12

12X18

.......

Disc. factors

1m

6m

12m

18m

......

Pre-crisis: from a market quoted 1m maturity instrument! How do we compute the 1m disc. factor?

After-crisis: there is no market quoted 1m maturity instrument with a 6m euribor underlying...

Raffaele Giura Interest rate yield curves before and after the crisis

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Does it help to add more F.R.A.s?

0m F.R.A. 0X6 1m F.R.A. 1X7

6m

7m

2 market instruments..

d1m

d6m d7m

..not enough to compute 3 discount factors...

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Interpolation could be an answer..

F.R.A. Set n1 0X6 6X12 12X18 18X24 .......... 0x6 6x12 12x18 18x24 d.factors 6m 12m 18m 24m ...... ......... Interpolation

F.R.A. Set n2 1x7 7x13 1m

1X7

7X13

7m

13m

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Interpolation: important to run stress tests on the results. Constrained cubic spline on rate*time..
4.5 4 3.5 3 2.5 2 1.5 06-07-09

18-11-10

01-04-12

14-08-13

27-12-14

10-05-16

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Interpolation: important to run stress tests on the results. Quartic spline on fwd-fwd rates..
4.5 4 3.5 3 2.5 2 1.5 06-07-09

!!

18-11-10

01-04-12

14-08-13

27-12-14

10-05-16

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What about discounting?

In examples so far we built the forwarding curve from market sets made only of F.R.A. When you put to zero F.R.As NPV you put to zero also their cashflows. This allowed us to ignore the discounting curve issue In real market conditions you have to include in the market set from which you build the curve also the I.R.S. Once you start using multicashflow I.R.S. discounting matters In practice you build the discounting curve first; then you find the forwarding curve that zeroes the NPVs of your set of at the money market instruments

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Discounting and the crisis

Before the crisis discounting was based on the single Euribor curve The crisis implied that you have to use multiple curves. It wouldnt make sense to discount with a forwarding curve whose purpose is only to compute the forward fixings. You need something specific for discounting cashflows The crisis increased the awareness of the counterparty risk, so that on the interbank swap markets most of the new deals are now centrally cleared or at least protected by a CSA agreement.

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CSA discounting

The discounting rate for the cashflows of a collateralized deal has to be computed keeping in account the CSA features. You can have: Standard CSA, that means: daily NPV calculations; daily margin calls; cash only collateral, in the same currency in which the deal is denominated, yielding the overnight rate. Market consensus is Eonia discounting here for EUR deals. Non standard CSA, that means: collateral delivery options, collateral paid in currencies different from the one in which the deal is written, margin call thresholds, asymmetrical collateral and in general any feature different from the standard CSA. Here specific discounting functions have to be built

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LCH-Swapclear discounting

Nowadays most players in the EUR I.R.S. market are clearing their new deals in Swapclear. This means that the I.R.S. prices seen in the broker pages are meant to be good for counterparties that are clearing in Swapclear Swapclear variation margin system works in a way comparable with a standard collateral. This allows you to discount the cashflows of the EUR deals cleared in Swapclear at Eonia

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LCH-Swapclear regulation

11.7 Price Alignment Interest The Clearing House collects and distributes changes in the net present value (NPV) of trades registered with it on a daily basis () The Clearing House (...) distributes PAI on cumulative variation margin received from an SCM. The PAI rate for Sterling is SONIA (Sterling Overnight Index Average); for Euro is EONIA (Euro Overnight Index Average); for USD is FEDFUNDS1; for YEN is TONAR, for Swiss Francs is TOIS, and for Danish, Norwegian Krone and Swedish Krona, Australian, Hong Kong, New Zealand and Canadian Dollars, Polish Zloty and South African Rand, the appropriate overnight input into our end-of-day yield curves is used.

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A second solution for forwarding curves: Eonia + spread

Eonia (Euro OverNight Index Average) is an interest rate index computed as a weighted average of all overnight unsecured lending transactions in the Euro interbank market. By comparison the Euribor calculation only takes into account offered rates and not rates at which transactions have been made. The banks contributing to Eonia are the same as the Panel Banks quoting for Euribor. Eonia can be used as reference rate for Euro denominated I.R.S. where variable interests are reset daily, compounded, and paid at the end of each interest rate period.
Fixed leg cashflow Floating leg cashflow Daily compounding at Eonia rate

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The Eonia curve building: practical advantages vs Euribor curve building after the crisis (1)
When you consider the Eonia swap market you can still correctly compute the 3X6m forward rate from the 3m and 6m spot rates.There is no 3m vs 6m basis as in the Euribor swap market.
0X3m Eonia swap 3X6m Eonia swap

The fixings are the same

0X6 Eonia swap

Raffaele Giura Interest rate yield curves before and after the crisis

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The Eonia curve building: practical advantages vs Euribor curve building after the crisis (2)
When we build the Eonia forwarding curve we do not have to fill in the in between discount factors in an arbitrary way, as we did on the Euribor curve. We can compute them directly from market quoted instruments (the 1m discount from the 1m Eonia rate) Lastly if we are also discounting at Eonia (which Ill assume we are doing from now on) we will have the same curve used both for forwarding and discounting: in other worlds the Eonia swaps can still be priced correctly with the old single curve framework (even if the eonia curve bootstrapping has its own specific features)

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So far so good with Eonia: but I need Euribor curves...

To build an Euribor curve from an Eonia curve we need to build an Euribor-Eonia forward spread term structure Any Euribor fixing can be seen as the sum of the equivalent Eonia swap rate and a spread So if we had, for example, to compute the 1X4 F.R.A. we could think to compute the 1X4 Eonia swap rate first and after add the appropriate spread in order to get the correct price

0m

1m 1X4m F.R.A.

4m

0m 1m

4m

1X4m Eonia + Spread

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What does the Euribor3m-Eonia spread tell us (a traders point of view)

Intuitively this represents the difference between lending directly for 3 months and rolling cash o/n for the same 3 months. On the market the Euribor-Eonia spread is supposed to depend on: The offer vs mid spread. The Euribor is an offer rate, the Eonia is a traded (mid) rate. This factor should amount to 6.25bp = (Euribor-Euribid)/2 and should remain constant Counterparty and liquidity risk, wich together give a measure of the banking sector stress, as perceived by the interbank money markets (Morini 2009)

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Euribor-Eonia forward spread term structure

The Euribor-Eonia forward spreads are not constant. They have a term structure and can be bootstrapped from the Euribor and Eonia market data
E ur ibor 3m-E onia S pd

0 .3 0 .2 5 0 .2 0 .1 5 0 .1 0 .0 5 0
06- Ju l- 0 9 18- Nov - 1 0 0 1- A pr - 1 2 14 - A ug - 13 2 7- Dec - 14 10 - May - 1 6 22- Se p- 1 7 04 - Feb- 1 9 1 8- Jun- 20 31 - Oc t- 21

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Generic 3m Euribor forward fixing

Once we built an Eonia curve and an Euribor-Eonia spread term structure we can accordingly compute any implied forward fixing:
Euribor3m-Eonia Spd

Eonia implied daily fwds

5 4.5 4 3.5 3 2.5 2 1.5 1 0.5 0

0.3 0.25 0.2 0.15 0.1 0.05 0

06-Jul-09 18-Nov-10 01-Apr-12 14-Aug-13 27-Dec-14 10-May-16 22-Sep-17 04-Feb-19 18-Jun-20 31-Oct-21

18-Nov- 01-Apr- 14-Aug- 27-Dec- 10-May- 22-Sep- 04-Feb- 18-Jun10 12 13 14 16 17 19 20

E.g. 27m Euribor3m-eonia spread + 27x30m Eonia swap = 27x30m F.R.A.

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Euribor swaps as Eonia swaps + spread

When you are pricing an Euribor swap you can think to it as an Eonia swap plus a changing spread on the floating leg. These spreads are taken from the forward spread term structure we have just seen
Eon ia im p lied daily fw ds
5 4.5 4 3.5 3 2.5 2 1.5 1 0.5 0 18-Nov10 01-Ap r12 14-Au g - 27-Dec- 10-May- 22-Sep - 04-F eb - 18-Ju n 13 14 16 17 19 20
E u r ib o r 3 m - E o n ia S p d

0 .3

Euribor fixings

Eonia fixings + spreads

0 .2 5 0 .2 0 .1 5 0 .1 0 .0 5 0
0 6 - Ju l- 0 9 1 8 - No v - 1 0 01-A pr-12 14-A ug-13 2 7 - De c - 1 4 1 0 - Ma y - 1 6 22-Sep-17 0 4 - Fe b - 1 9 1 8 - Ju n - 2 0 3 1 - O c t- 2 1

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Comparing the two forwarding curve solutions (1)

Eonia + spread needs a developed Eonia swap market extended to long and extra long maturitites: you can not apply this kind of solution to all currencies. However, if you discount at Eonia equivalent rates, you will need an Eonia curve anyway In real life curve calibration can be more difficult, mainly in market stress situations Eonia + spread solution is likely to require more work to implement it in the pricing, risk and revaluation systems

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Comparing the two forwarding curve solutions (2)

On the other side if you use Eonia + spread you do not have to rely on values of the in between discount factors which are at the end filled in by an arbitrary way Eonia + spread could allow you to extract more informations from the yield curve. You have two different term structures, each one doing a different job. From the Eonia curve term structure you can extract informations on how interest rates are expected to evolve in the future; from the Euribor-Eonia term structure you can extract informations on the way the banking sector stress is expected to evolve in the future

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If needed slides

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CSA at work: day 1

Day 1, at 12.00: IRS trader pays 1 bn 10y swap vs Euribor 6m at 3.32 to counterparty Day 1, at 17.15: close of business: -10y vs 6m swap rate went up -swap NPV now = 9 mn euro -counterparty will post (give us) 9mn eur as collateral

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CSA at work: day 2

Day 2, at 17.15: close of business -no new deal has been made -market moved: swap NPV is now = 10mn -counterparty should pay us 1mn ( 10mn 9mn = NPV(day2)-NPV(day1) -we should pay to the counterparty the 1 day interests on the 9 mn we received yesterday; the rate of interest we use for this calculation is the CSA rate; if we agreed to use the overnight as CSA rate, and the overnight was 1.25% we have to pay 312.5 eur (9mn * 1.25% / 360) -net payment: we rec 999.687,5 eur

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Rate for discounting when deals are inside a CSA

For a discussion on this matter see Willmott forum at:

http://www.wilmott.com/messageview.cfm?catid=4&threadid =68959&FTVAR_MSGDBTABLE=

Raffaele Giura Interest rate yield curves before and after the crisis

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Why we should discount the cashflows of the collateralized deals with the CSA rate? Test explanation

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What is a future cashflow worth?

NPV
days 0X1 1X2 2x3 3x4 4x5 5x6 6x7 7x8 n x n+1.. Disc. rates

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