Perturbation Methods in Credit Derivatives

CHAPTER 13Risk‐Free Rates

13.1 BACKGROUND

In our discussion hitherto we have assumed that interest rate payments are always based on LIBOR rates, or else swap rates which are derived from forward LIBOR rates and are essentially weighted averages thereof. However, it is by now well known that, in the wake of a number of scandals which came to light in 2012 involving illicit manipulation of LIBOR interest rates, the financial world is in the throes of a major transition away from such term rates, set in advance of the period for which they are applicable, in favour of backward‐looking rates which are set daily, with the rates compounded over the period for which interest is to be paid. This helps avoid the possibility that particular LIBOR term rates can be manipulated on a particular day to the advantage of one or more financial institutions.

It also addresses the problem which arose in the wake of the 2007 credit crunch that different tenors of LIBOR had different spread levels reflecting the fact greater counterparty default risk was embedded in loans of longer tenors. We will return to this problem and the strategies which have been proposed to address it in Chapter 14. As explained by Lyashenko and Mercurio [2019]:

In 2013–2014, the Financial Stability Board (FSB) conducted fundamental reviews of major interest rate benchmarks and recommended developing alternative nearly risk‐free rates (RFRs) that are better suited as the reference rates for certain financial transactions. ...