Compounding Conventions for Tenor Basis Swaps
Summary
The discussion addresses how to interpret a quoted spread on the shorter leg of a tenor basis swap when that leg’s rate accrues over shorter periods but pays on the longer leg’s schedule. It explains that the term sheet or governing market documentation specifies the compounding method. The described alternatives include no compounding, compounding both the reference rate and spread, compounding the rate while excluding the spread, and flat compounding, where the rate compounds without the spread but the interim amount includes the spread.
The response says flat compounding is common for many liquid G4 basis swap pairs and that the spread is typically quoted on the shorter-tenor leg. It identifies EONIA versus three-month swaps and SOFR versus fed funds swaps as exceptions using spread-exclusive compounding. These are convention summaries, not universal rules: the applicable confirmation or term sheet governs, and conventions can vary by currency and product.
Key ideas
- The governing documentation specifies how a tenor basis swap compounds its reference rate and spread.
- Compounding conventions differ in whether the rate, spread, or both enter interim accrual amounts.
- Flat compounding combines rate-only compounding with spread-inclusive interim amounts.
- The spread is typically quoted on the shorter-tenor leg in the examples discussed.
- Some named swap pairs use spread-exclusive compounding instead of the common flat convention.
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# tenor basis swap spreads and compounding # tenor basis swap spreads and compounding Let's say I have a 3mv6m tenor basis swap that is quoted at a spread of x bp (and it is a spread on the 3m leg while the 6m leg is the flat leg). Nowadays, I think the convention in most currencies is to compound the 3m rate so that there is a single payment only at the 6m schedule. For this case I have 2 questions related to the spread and handling of the compounding: 1) is the spread of x bp quoted as a 3m compounded spread (like it was before when there was no compounding) or a 6m compounded spread (to be directly added to a 3m rate compounded to 6m)? 2) assuming the x bp spread is a normal 3m spread: is the implied 3m cashflow (incl. spread cashflow) compounded with the 3m rate flat (i.e. no compounding with spread included)? Anybody trading tenor basis swaps here? TIA for any feedback. ## Answer by Magic is in the chain (score 2) https://quant.stackexchange.com/a/45364 This would be specified in the ISDA or term sheet. There are four alternative methods: No compounding: Meaning neither the rate nor the spread get compounded. Compounding: Meaning both the spread and the libor rate get compounded. Spread exclusive compounding:Meaning the libor get compounded but the spread does not. This was not covered by ISDA 2006 but was quite widespread. Flat compounding: Slightly more involved, but in your example of 3mV6m, would mean that the first 3m of the quarterly leg gets compounded at the interest rate (excluding spread) but then the amount of first sub period would include spread. So you can see it’s half way between the two extremes. The calculations are detailed in the below excel file: https://www.isda.org/a/aKiDE/compounding-worked-examples.xls ## Answer by oronimbus (score 2) https://quant.stackexchange.com/a/45855 Convention for most currencies is flat compounding. This includes the most liquid G4 basis swaps: - EUR 3m vs 6m, 3m vs 12m, 1m vs 3m - USD 1m vs 3m, 3m vs 6m - GBP 3m vs 6m, 1m vs 3m - JPY 3m vs 6m, 1m vs 6m, 1m vs 3m Typically the spread is quoted in terms of the leg with the shorter tenor. Two notable exceptions are EONIA v 3m and the (relatively new) SOFR v FF basis swaps. Here we exclude the spread rather than use flat compounding.
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