Determinants of the Multiple-Term Structures from Interbank Rates

Abstract

The classic relationship between deposit rates and interest rate derivatives has been fractured since August 2007. Uncertainty in the interbank money market has increased the risk premia differentials on unsecured deposits rates of different tenors, such as Euribor, leading to a new pricing framework of interest rate derivatives based on multiple curves. This article analyzes the economic determinants of this new multi-curve framework. We employ basis swap (BS) spreadsfloating-to-floating interest rate swaps-as instruments for extracting the interest rate curve differentials. Our results show that the multi-curve framework mirrors the standard single-curve setting in terms of level, slope and curvature factors. The level factor captures 90% of the total variation in the curves, and this factor significantly covaries with a proxy for systemic risk.Moreover, the curve residuals are significantly correlated with interbank liquidity. Our empirical findings also show unidirectional causality running from risk (and liquidity) to level (and noise) factors.Keywords: Basis swap, noise measure, credit risk, liquidity risk, capital arbitrage JEL classification: G01, G12, G15, G32 AbstractThe classic relationship between deposit rates and interest rate derivatives has been fractured since August 2007. Uncertainty in the interbank money market has increased the risk premia differentials on unsecured deposits rates of different tenors, such as Euribor, leading to a new pricing framework of interest rate derivatives based on multiple curves.This article analyzes the economic determinants of this new multi-curve framework. We employ basis swap (BS) spreads -floating-to-floating interest rate swaps-as instruments for extracting the interest rate curve differentials. Our results show that the multi-curve framework mirrors the standard single-curve setting in terms of level, slope and curvature factors. The level factor captures 90% of the total variation in the curves, and this factor significantly covaries with a proxy for systemic risk. Moreover, the curve residuals are significantly correlated with interbank liquidity. Our empirical findings also show unidirectional causality running from risk (and liquidity) to level (and noise) factors.

Dissecting interbank risk using basis swap spreads

“…This procedure requires the use of the BS pricing formulas provided in Appendix A. A more detailed discussion could be found in Lafuente, Petit, and Serrano (2015).…”