Friday, April 27, 2012

libor vs gov bond -- 2 benchmarks

Most credit instruments, all (secured/unsecured) loans, all IR products, most derivatives based on FX, IR or credit (I'd say virtually all derivatives) need to apply a spread on a reference yield. If the deal has a "maturity date" or "delivery date", "call date" [1], then we look for that date on the reference yield curve and read a yield number like (222 bps pa) off that curve. That number is the reference yield, a.k.a reference spot rate. You can convert that to a discount factor easily. There are also straightforward and well-defined conversions to/from fwd rates, driven by arbitrage principles.

[1] perhaps among a series such dates.

Question is which reference yield curve to use. Most companies use a single, consolidated curve for each currency. One of the biggest muni security trading desks in the world has just one yield curve for USD, which is typical. Another megabank has a single live Libor curve for the entire bank, updated by the minute.

If you use more than one yield curve built from different data sources, then for any maturity date, you would read 2 yield numbers off them. If sufficiently different, you create arbitrage opportunity and your valuations are inconsistent.

On the short end of the IR space the reference curves are 1) Libor 2) Fed Funding (USD only). Libor is more popular.

On the long end, T-bond dominates the USD market. Many governments issue similar bonds to create a reference riskless rate.

However, the most liquid IR instruments are probably more realistic and reliable as a reflection of market sentiment. ED futures, Bund futures, T-bond inter-dealer market rates are examples.

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