Short-Term Rates and Their Derivatives
Short-term borrowing and lending, whether through marketable securities or loans, is a large and important segment of financial markets. While these short-term transactions occur at very many different rates, most of these rates are actually spreads off a smaller number of benchmark rates. For example, a bank will charge a customer whatever rate it thinks appropriate for a one-month loan, but will probably start with the current level of one-month London Interbank Offered Rate (LIBOR) and add a spread appropriate for the credit risk of a loan to that customer.
This chapter covers two of the most widely used short-term rate benchmarks, namely the set of LIBOR indexes and the federal (fed) funds rate. In addition to defining and discussing the rates themselves, this chapter presents the securities used to hedge exposures to those rates, Forward Rate Agreements (FRAs) and Eurodollar futures in the case of LIBOR and fed funds futures and Overnight Indexed Swap (OIS) in the case of the fed funds rate. In addition to the basic material, this chapter includes an application showing how to extract implied probabilities of the Board of Governors of the Federal Reserve System policy changes from fed fund futures prices, a case study of shorting the Treasury Eurodollar (TED) spread of a particular U.S. Treasury bond, and a discussion of the LIBOR-OIS spread as a leading indicator of system-wide financial stress.
A final point to be made here ...