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Separating Credit and Rate Expectations in Term LIBOR

Article Quant Q&A · Author: Ulysses
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Summary

The document asks how to interpret the difference between overnight federal funds and longer-maturity USD LIBOR. It frames the term rate as potentially reflecting both bank credit risk and expectations of future policy rate increases, and considers whether rates in other currencies might help isolate those components. It gives quoted examples for overnight, two-month, and three-month rates, but does not establish a decomposition or provide a worked method for estimating either contribution.

The discussion is exploratory and ends by soliciting suggestions for a proxy, since the author notes there is no directly comparable two- or three-month federal funds rate. Any cross-currency comparison would also need to account for differences in the currencies and markets. The document is useful as a statement of the identification problem, but it offers no empirical conclusion or validated estimate.

Key ideas

  • Term LIBOR can reflect expected policy rates over its maturity as well as bank credit risk.
  • The author seeks a proxy for term federal funds rates to separate those components.
  • LIBOR rates in other currencies are proposed as a possible comparison, with acknowledged limitations.
  • The document raises the estimation question but does not resolve it.

Tags

Fixed incomeUS marketsStatistics
Full text
# Fed Funds Rate: longer maturities


# Fed Funds Rate: longer maturities












FFR published by Fed Bank of NY is the average rate US banks charge each other for the overnight loans of their reserves required by the Fed regulations. Since Fed acts similar to a clearing house here, I guess there is little credit risk involved. For that reason we may as well expect LIBOR rate for the very same maturity to be a bit higher. In fact, currently overnight USD LIBOR is 12 bps whereas FFR is 13-14 bps, so that does not quite hold.

Nevertheless, I'm looking into longer maturities LIBOR and of course the feature much higher rates. For example, 2-months is 25 bps and 3-months is 30 bps. I wonder which part of that comes from the credit risk, and which comes from the potential rate hike before that maturity. Unfortunately there is no 2- or 3-months FFR available, so I wondered whether there's any proxy for that: that would help estimating the rate hike component in LIBOR rates. From the other direction, I thought of estimating the credit risk component from LIBOR rates in other currencies (the less they are dependent on the US rates the better of course), and hence getting rate hike effect left. Any suggestions?

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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.