The Zeeman Effect in Finance: Libor Spectroscopy and Basis Risk Management
AbstractOnce upon a time there was a classical financial world in which all the Libors were equal. Standard textbooks taught that simple relations held, such that, for example, a 6 months Libor Deposit was replicable with a 3 months Libor Deposits plus a 3x6 months Forward Rate Agreement (FRA), and that Libor was a good proxy of the risk free rate required as basic building block of no-arbitrage pricing theory. Nowadays, in the modern financial world after the credit crunch, some Libors are more equal than others, depending on their rate tenor, and classical formulas are history. Banks are not anymore “too big to fail”, Libors are fixed by panels of risky banks, and they are risky rates themselves. These simple empirical facts carry very important consequences in derivative’s trading and risk management, such as, for example, basis risk, collateralization and regulatory pressure in favour of Central Counterparties. Something that should be carefully considered by anyone managing even a single plain vanilla Swap. In this qualitative note we review the problem trying to shed some light on this modern animal farm, recurring to an analogy with quantum physics, the Zeeman effect.
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Bibliographic InfoPaper provided by University Library of Munich, Germany in its series MPRA Paper with number 42247.
Date of creation: 31 Oct 2011
Date of revision: 27 Oct 2012
crisis; liquidity; credit; counterparty; risk; fixed income; Libor; Euribor; Eonia; yield curve; forward curve; discount curve; single curve; multiple curve; collateral; CSA-discounting; liquidity; funding; no arbitrage; pricing; interest rate derivatives; Deposit; FRA; Swap; OIS; Basis Swap; Zeeman; Lorentz; quantum mechanics; atomic physics;
Find related papers by JEL classification:
- E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
- G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
- G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
- Fries, Christian P., 2010. "Discounting Revisited. Valuations under Funding Costs, Counterparty Risk and Collateralization," MPRA Paper 23082, University Library of Munich, Germany, revised 30 May 2010.
- Fabio Mercurio, 2010. "Modern Libor Market Models: Using Different Curves For Projecting Rates And For Discounting," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., World Scientific Publishing Co. Pte. Ltd., vol. 13(01), pages 113-137.
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