Scribd
Upload
166 views5 pages

Extending Usd Ois Curves Using Fed Funds Basis Swap Quotes: Background

This document describes two methods for extending USD overnight index swap (OIS) curves beyond the 10-year maturity using USD federal funds basis swap quotes. Method 1 bootstraps the OIS curve to match federal funds basis spreads, solving for longer-term OIS rates. Method 2 approximates longer-term OIS coupons using LIBOR swap rates, federal funds basis spreads, and a compounding adjustment. Cross-validation of the methods using recent market data found errors of less than 1 basis point, suggesting the extrapolation techniques provide accurate estimates of OIS rates beyond 10 years.

Uploaded by

dondan123
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
166 views5 pages

Extending Usd Ois Curves Using Fed Funds Basis Swap Quotes: Background

This document describes two methods for extending USD overnight index swap (OIS) curves beyond the 10-year maturity using USD federal funds basis swap quotes. Method 1 bootstraps the OIS curve to match federal funds basis spreads, solving for longer-term OIS rates. Method 2 approximates longer-term OIS coupons using LIBOR swap rates, federal funds basis spreads, and a compounding adjustment. Cross-validation of the methods using recent market data found errors of less than 1 basis point, suggesting the extrapolation techniques provide accurate estimates of OIS rates beyond 10 years.

Uploaded by

dondan123
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
You are on page 1/ 5

Page 1

EXTENDING USD OIS CURVES USING FED


FUNDS BASIS SWAP QUOTES
BACKGROUND
Currently for USD, OIS rates are not quoted in the marketplace beyond the 10-year maturity. In
order to support OIS discounting and dual-curve stripping, it is necessary to extend the OIS
curves beyond the 10-year maturity. This section describes methods for extending the OIS
curves to the 30-year maturity by harnessing USD Fed Funds (FF) basis swap quotes.
Despite having different conventions, such as pay frequency and compounding, both OIS and FF
basis swaps are defined in terms of the FF Effective Rate, FEDL01. As shown in {SWPM OIS
<GO>} and {SWPM FF <GO>}, OIS and FF basis swap cash flows are calculated based on the
forwards of the same index FEDL01, projected from the curves S42 and S85, respectively. Since
both the OIS curves S42 and the FF basis curves S85 are used to project forwards of FEDL01, the
valuation of OIS swaps and FF basis swaps can be carried out in principle using projections from
either curve. In other words, OIS swaps and FF basis spreads are observables of the same
underlying security, and, therefore, sensible inferences from each other should be possible in
an arbitrage-free environment. Extrapolation methods described below explore such
relationships between OIS and FF basis swaps.

METHOD 1: BOOTSTRAPPING OIS CURVES TO MATCH FF
BASIS SPREADS
The extrapolation Method 1 bootstraps the OIS curves S42 by evaluating FF swaps while using
S42 for FEDL01 projection. At each bootstrapping step, the discount factor is calibrated so that
the resulting FF basis spread matches the market quote.
Figure 1
1
illustrates this bootstrapping process, while the details appear in Appendix A. Suppose
hypothetically that OIS swaps are quoted only to the 5Y maturity and we need to calculate the
10Y OIS rate from the 10Y FF basis spread (in conjunction with the 10Y Libor swap rate). A 10Y
fixed-float FF basis swap can be set up as follows: a fixed leg receives 10Y Libor swap
(USSWAP10), and a floating leg pays daily averaged FF rate plus basis spread (USBG10). The PV
of the floating leg is dependent on curve S42 in which all swap rates are known except the 10Y
maturity. Therefore, the 10Y OIS rate can be solved by equating the PVs of both legs.

1
This is a customized SWPM screen and does not correspond to any standard deal supported by SWPM. It is
shown for illustration purpose and can be set up from an OIS swap with deal conventions modified as follows: fixed
leg matches LIBOR and floating leg matches FF, and OIS curve is used for discounting. The manual OIS striping step
is carried out by shifting the 10Y OIS rate in the curve tab to make PVs of both legs equal.

Page 2



Figure 1: Illustration of bootstrapping OIS rate using FF basis and Libor swap rate

METHOD 2: APPROXIMATE CALCULATION OF OIS
COUPONS USING LIBOR AND FF BASIS
In principle, OIS coupons can be calculated by using S85 to project FEDL01. But stripping S85 is
computationally expensive due to weighted daily average compounding in FF swaps. Method 2
intends to provide a quick approximation based on this idea.
Note that if OIS and FF swaps were to have the same compounding conventions, OIS swap rates
could have been calculated from the LIBOR curve with FF basis spread and fixed-leg convention
adjustment as shown in Figure 2.
2
Unfortunately, there is no easy way to account for the
compounding differences without actual a daily forward projection from S85, and this
compounding difference can account for about 1.5bps or more in OIS swap rates under the
current market conditions.
By ignoring minor discrepancies such as business day adjustment, the OIS coupon calculation
can be further approximated by an analytic formula without the need to actually carry out the
swap evaluations. Let
cN,23
,
cN,42
and
sN,85
denote the N-year Libor swap rate, OIS rate and FF
basis spread, respectively. The extrapolated OIS rate,
_(N,42)
, can be approximated as:

2
This is again a customized SWPM screen, which can be set up from a Libor swap with deal conventions modified
as follows: fixed leg matches OIS while FF spread is applied to float leg.

Page 3


Where:


A crude compounding adjustment is to assume a flat curve with rate equal to (Libor - FF basis)
and ignore compounding for weekends and holidays. Based on this flat curve assumption, the
OIS rate with compounding adjustment,
_(N,42)^'
, is computed as follows:




Figure 2: Rearranging FF swap for IOS approximation



Page 4


CROSS-VALIDATION RESULTS
In an effort to predict how well they will perform in estimating OIS rates beyond the quoted
10Y maturity, cross-validation is used to evaluate the extrapolation methods. It is carried out
for the 10Y OIS swaps by comparing quoted against implied rates from various methods using
only OIS rates to the 5Y maturity.
Figure 3(a) shows real-time market quotes of Libor and OIS rates on 2/18/11 (BGN). Note that
Libor and OIS track each other quite well, except for small rate spikes that appeared in only one
of them. The average bias of the errors is about 1bp after taking into account the FF basis
(Figure 3(b)). A remarkable agreement is observed between the implied and quoted rates for
both methods as shown in Figures 3(c) and (d). A small bias less than bp is observed, which is
likely the result of not making convexity adjustment in FF basis swap valuation. Similar error
characteristics are observed from extrapolation results on various other days.


(a) Quoted 10Y Libor and OIS rates (b) Errors if OIS is estimated as Libor-FF basis


(c) Extrapolation errors from Method 1 (d) Extrapolation errors from Method 2
Figure 3: Cross-validation results for 10Y OIS rates based on real-time quotes on 2/18/11



Page 5


BOOTSTRAPPING ALGORITHM FOR METHOD 1
Let
cN,23, cN,42
and
sN,85
denote the Libor swap rate, OIS rate and FF basis spread of the maturity
TN, respectively. We seek to bootstrap the OIS rate,
cN,42
, using
cN,23
and
sN,85
, assuming that the
OIS curve has been constructed up to the maturity T
N-1
, pursuant to the procedure described in
Error! Reference source not found. Constant-forward interpolation is used for curve 42 during
bootstrapping.
Notation
t
k,i
= i-th cash-flow payment date in k-th leg (k=1,2)
t
k,Ii
= t
k,i
- t
k,i-1
= day-counts fractions in i-th payment period in k-th leg
d
t
= discount factor at time t on the OIS curve
r
df,N
= constant OIS daily-forward rate in the interval (T
N-1
,T
N
)
PV
k
= PV of k-th leg

FF Basis Swap Using OIS Curve
The PVs in a FF basis swap are evaluated as follows:


Where:
r
wdf,j
= weighted average daily forward rate in j-th payment period in leg 2
=


n
j,k
= number of days in[t
2,j - 1
,t
2,j
] that accrue k days of interest
For example, n
j,3
is the number of Fridays in j-th period that are part of a long weekend. Note
that both PVs are function of r
df,N
, which can be solved from PV
1
= PV
2
. The bootstrapping
procedure can be carried out efficiently using pre-computed {n
j,k
}.

You might also like