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With the heightened focus on credit markets since the 1998 credit meltdown and the shrinking supply of U.S. Treasury Notes and Bonds, the importance of the LIBOR market has increased significantly. This increased emphasis caused us to revisit the methodology for constructing the LIBOR curve and improve upon the interpolation methodology for computing LIBOR forward rates. The LIBOR curve is constructed using a bootstrap process. Marks on liquid instruments with increasing maturities are used to imply arbitrage free forward rates. The instruments used to construct the curve are as follows: money market rates for short maturities, Eurodollar futures contracts for intermediate maturit ies, and swap spreads/rates for long maturities.
Bootstrapping the LIBOR curve entails creating a discount function, which represents the present value of a dollar to be received in the future. From this discount function all other curves, e.g. spot, par, forward, can be derived. The discount function should have a value of 1 today and monotonically decrease with maturity. For the first part of the bootstrapping process we use money market where rates which are quoted for 7d, 1m, and 3m maturities. It is straightforward to calculate the appropriate discount using the following formula:
(t) =
Where
1 . 1 + ( t0 , t ) L(t 0 , t )
(t 0 , t ) is the day count fraction from time t0 to t, and L( t0 , t ) is the money market rate for the period t0 to t. The day count basis used to calculate in the US dollar market is Act/360.
Money market rates are used to determine appropriate discounts only until the next IMM futures contract settlement date. At that point Eurodollar futures quotes are used to determine implied forward rates. IMM dates occur the Monday prior to the third Wednesday of March, June, September and December. Eurodollar quotes can be converted to implied forward rates by subtracting the quote, q, from 100. If we let ti represent the IMM date of the i-th Eurodollar futures contract and log-linearly interpolate the money market discount factors to determine ( t1 ) then subsequent Eurodollar futures contract discount factors can be calculated via:
( t i+1 ) =
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1 = rn fix (t i1 , ti ) ( ti ) + (t mn ) .
i =1
m n
Where
rn is the fixed rate for a swap of tenor n years which pays a coupon of frequency m, and fix (t i1 , t i ) is the day count fraction from time ti-1 to ti for the fixed leg of the swap.
For US dollar swaps the fix leg pays a semiannual coupon and day counts are determined using a 30/360 basis, or m = 2 and fix = 1 / 2 . Our goal is to determine the discounts that make the above relationship true subject to the prior constraint
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Forward Rate
20050103
20100103
20150103
20200103
20250103
20300103
Date
3m Fwd 3m Fwd (new)
The difference between the resulting discount functions is so small that the two curves cannot be distinguished on the same plot. Below the difference between the resulting discount functions is plotted. Please take note of the size of the differences.
20050103
20100103
20150103 Date
20200103
20250103
20300103
The small differences above give rise to similarly small differences in valuations. It should be noted that with suitable choices for day count basis and frequency of coupon payment this methodology has been easily extended to non-dollar LIBOR markets as well.
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