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BOND PRICING, INTEREST-RATE PROCESSES, AND THE LIBOR MARKET MODEL

Ser-Huang Poon and Richard Stapleton

in Asset Pricing in Discrete Time: A Complete Markets Approach

‘Bond Pricing, Interest-rate Processes, and the LIBOR Market Model’ uses the complete market, pricing kernel approach to value bonds, given stochastic interest rates. To value interest-rate ... More

‘Bond Pricing, Interest-rate Processes, and the LIBOR Market Model’ uses the complete market, pricing kernel approach to value bonds, given stochastic interest rates. To value interest-rate derivatives, one important and practical problem is to model bond prices and interest rates with the correct drifts. The authors derive here the drift of the bond prices and interest rates under the period-by-period risk-neutral measure. As a special case, they derive the drift of the forward London Interbank Offer Rate (LIBOR) in what is generally known as the LIBOR Market Model.Less

LIBOR and Swap Market Models

Tomas Björk

in Arbitrage Theory in Continuous Time

A number of models have been successfully developed wherein the theoretical prices for caps, floors, and swaptions produced by the model are of the Black-76 form. In these models, discrete market ... More

A number of models have been successfully developed wherein the theoretical prices for caps, floors, and swaptions produced by the model are of the Black-76 form. In these models, discrete market rates are modelled like LIBOR rates in the LIBOR market models or forward swap rates in the swap market models; and under a suitable choice of numeraires, market rates can be modelled log normally. LIBOR caps and the market practice for pricing and quoting these instruments are discussed. It is shown that given a swap market model, the LIBOR rates will not be lognormal; thus, LIBOR market models and swap models are generally incompatible. Practice exercises are included.Less

Reforming benchmarks

Oonagh McDonald

in Holding bankers to account: A decade of market manipulation, regulatory failures and regulatory reforms

This chapter describes the effects of the Financial Stability Board review of interest rate benchmarks. The board’s report recommended a number of measures to help improve security, notably by ... More

This chapter describes the effects of the Financial Stability Board review of interest rate benchmarks. The board’s report recommended a number of measures to help improve security, notably by underpinning existing IBORS with transactions data and by developing alternative, nearly risk-free rates. New benchmarks would be developed with reference to the ISOCO Principles published in July 2013. The chapter explains these principles and how they were put into practice.Less

Market Models

Claus Munk

in Fixed Income Modelling

The term structure models studied in preceding chapters involve assumptions about the evolution in one or more continuously compounded interest rates, either the short rate or the instantaneous ... More

The term structure models studied in preceding chapters involve assumptions about the evolution in one or more continuously compounded interest rates, either the short rate or the instantaneous forward rates. However, securities such as caps, floors, swaps, and swaptions depend on periodically compounded interest rates such as spot or forward LIBOR rates and spot or forward swap rates. For the pricing of these securities it seems appropriate to apply models that are based on assumptions on the LIBOR rates or the swap rates, and that is exactly what the market models do. LIBOR market models are based on assumptions on the evolution of the forward LIBOR rates, whereas swap market models are based on assumptions on the evolution of the forward swap rates. This chapter presents a general modelling framework, with special attention given to the so-called lognormal market models in which the derived prices for some caps or swaptions are consistent with the standard Black formula frequently applied by market practitioners. Alternative market models are also discussed.Less

The evolution of LIBOR

Oonagh McDonald

in Holding bankers to account: A decade of market manipulation, regulatory failures and regulatory reforms

This chapter provides a brief history of LIBOR, the London Interbank Offered Rate, tracing both market developments and the macro-economic and regulatory environment in which it was created. ... More

This chapter provides a brief history of LIBOR, the London Interbank Offered Rate, tracing both market developments and the macro-economic and regulatory environment in which it was created. Beginning as an informal measure used in the London Eurodollar market of the 1960s, LIBOR made the transition to a formal benchmark in the mid-1980s, eventually becoming the most widely used benchmark in the world by the late-1990s.Less

Manipulation abounds

Oonagh McDonald

in Holding bankers to account: A decade of market manipulation, regulatory failures and regulatory reforms

This chapter charts the loss of faith in LIBOR that began to set in during the Financial Crisis, particularly following two articles in the Wall Street Journal. Investigation by the regulators ... More

This chapter charts the loss of faith in LIBOR that began to set in during the Financial Crisis, particularly following two articles in the Wall Street Journal. Investigation by the regulators subsequently revealed that a number of early warnings had been overlooked, and that certain banks had been distorting rates since at least 2005. Drawing on FSA reports, the chapter demonstrates the day-to-day manipulation practiced by traders at Barclays, the Royal Bank of Scotland and UBS.Less

Yet more banks are involved

Oonagh McDonald

in Holding bankers to account: A decade of market manipulation, regulatory failures and regulatory reforms

This chapter sets out the ways in which other banks manipulated LIBOR, using the same techniques and for the same reasons. As the Final Notice to UBS makes clear, the methods used were due in large ... More

This chapter sets out the ways in which other banks manipulated LIBOR, using the same techniques and for the same reasons. As the Final Notice to UBS makes clear, the methods used were due in large part to one trader moving from one bank to another, so that networks of contacts were established.Less

Who knew what when?

Oonagh McDonald

in Holding bankers to account: A decade of market manipulation, regulatory failures and regulatory reforms

In this chapter the focus is on the comments and claims made about LIBOR prior to the beginning of the formal investigations by the FSA and the CFTC. As usual, after any scandal is revealed, the ... More

In this chapter the focus is on the comments and claims made about LIBOR prior to the beginning of the formal investigations by the FSA and the CFTC. As usual, after any scandal is revealed, the question immediately arose as to why the regulators had not discovered the wrongdoing earlier and taken action against those involved. This chapter sets out who knew what, considering the reasons both for the failure to detect what was going on with LIBOR and the alleged failure to take prompt action.Less

Benchmarks

Onnig H. Dombalagian

in Chasing the Tape: Information Law and Policy in Capital Markets

This chapter provides an overview of the regulation of benchmarks and benchmark products. It begins with a discussion of the types of benchmarks used in financial markets, such as stock, debt and ... More

This chapter provides an overview of the regulation of benchmarks and benchmark products. It begins with a discussion of the types of benchmarks used in financial markets, such as stock, debt and other asset-based indexes and interest rate indexes, such as LIBOR. It continues with a discussion of US case law and regulation governing the commercial use of benchmarks in designing and trading financial products, such as derivatives and exchange-traded funds. It then discusses regulatory concerns regarding the integrity of benchmark inputs, the calculation of benchmarks, and competition among benchmark products and markets. It ends with a discussion of approaches to regulating benchmark administration, governance and submissions, as well as the role of exchanges and regulators in the listing of benchmark contracts.Less

Bonds and Interest Rates

Tomas Björk

in Arbitrage Theory in Continuous Time

In this chapter, the reader is introduced to the basic facts and concepts concerning bond markets.

Libor Market Models

Tomas Björk

in Arbitrage Theory in Continuous Time

This chapter presents the LIBOR market models. These models, which produce lognormal interest rates, are widely used in the industry, can be calibrated to the market cap curve and used to price and ... More

This chapter presents the LIBOR market models. These models, which produce lognormal interest rates, are widely used in the industry, can be calibrated to the market cap curve and used to price and hedge exotic interest rate derivatives. They involve a highly nontrivial use of the change of numeraire technique discussed in Chapter 15.Less

Models of the Yield Curve and Term Structure

Tom P. Davis and Dmitri Mossessian

in Debt Markets and Investments

This chapter presents an overview of the modern state of term structure modeling techniques. It provides an analytical framework that is applicable to all short rate models and considers them from ... More

This chapter presents an overview of the modern state of term structure modeling techniques. It provides an analytical framework that is applicable to all short rate models and considers them from the point of view of the classic approach of pricing by replication. The market price of risk and its relation to the drift of a short rate model are important considerations in modeling the term structure. The notable short rate models used in the industry for relative value pricing are introduced with a brief description of the class of affine short rate models employed for forecasting the real-world dynamics of bond prices. The chapter also includes a description of the Heath-Jarrow-Morton derivative pricing framework and an analysis of the LIBOR market model.Less

“I Think We Got Away with It”: Benchmark Manipulation

Pierre-Hugues Verdier

in Global Banks on Trial: U.S. Prosecutions and the Remaking of International Finance

This chapter examines the enforcement campaign against manipulation of interest rate and foreign exchange benchmarks by traders and other employees of global banks. After reviewing the history, ... More

This chapter examines the enforcement campaign against manipulation of interest rate and foreign exchange benchmarks by traders and other employees of global banks. After reviewing the history, functioning, and weaknesses of LIBOR, the world’s most important interest rate benchmark, the chapter relates how the banking industry, banking regulators, and central bankers responded ineffectively to signs of LIBOR manipulation that emerged in 2008. By contrast, robust enforcement actions spearheaded by the U.S. Department of Justice and the Commodities Futures Trading Commission, beginning with the Barclays case in 2012, attracted worldwide attention. They led directly to parliamentary investigations, leadership turnover at some banks, and significant domestic and international benchmark reforms, culminating with an industry-wide shift away from LIBOR toward more reliable indices. Likewise, the foreign exchange manipulation scandal and related prosecutions led to the adoption of international reforms. In both cases, several individuals were also charged criminally, most notably UBS trader Tom Hayes. By using its authority over global banks to protect the integrity of widely used financial benchmarks that have the characteristics of public goods, U.S. actions benefited users of these benchmarks around the world.Less

Introduction: The Bank Culture Puzzle

Huw Macartney

in The Bank Culture Debate: Ethics, Values, and Financialization in Anglo-America

This chapter introduces the bank culture debate that took place in the political realm. It then explains that the political debate was based on a very narrow reading of bank culture, which focused on ... More

This chapter introduces the bank culture debate that took place in the political realm. It then explains that the political debate was based on a very narrow reading of bank culture, which focused on improving market conduct via greater market discipline and ethical reforms. The idea was to make bankers behave better. The chapter argues however, that there are compelling structural pressures—under financialization—that determine bank culture in Anglo-America, but which were conspicuously absent from the political debate. The chapter explains why policymakers avoided the more challenging debate about bank culture.Less

UK Responses and the Second Phase

Huw Macartney

in The Bank Culture Debate: Ethics, Values, and Financialization in Anglo-America

This chapter focuses on the culture of banking debate that emerged following the LIBOR scandal in 2012 in the UK. It shows a range of the harder, institutional and regulatory measures and penalties ... More

This chapter focuses on the culture of banking debate that emerged following the LIBOR scandal in 2012 in the UK. It shows a range of the harder, institutional and regulatory measures and penalties that were introduced to remedy bank culture. The chapter then moves to discuss the softer, normative agenda that also focused on bank culture change. The chapter contends though, that in both cases state managers were as concerned about tackling the legitimacy crisis as they were about actually improving bank culture. The chapter also shows the glaring absence of a debate on the structural causes of banking culture.Less

Interest as damages and interest on damages

Andrew Burrows

in Remedies for Torts, Breach of Contract, and Equitable Wrongs

The law on interest in English law is a tangled web. This is principally because the common law traditionally set itself against awards of interest and this has resulted in the piecemeal ... More

The law on interest in English law is a tangled web. This is principally because the common law traditionally set itself against awards of interest and this has resulted in the piecemeal intervention of statutes which allow the award of interest in specific situations. In the leading modern case of Sempra Metals Ltd v IRC the House of Lords reformed the common law as regards awards of interest as compensatory damages for a tort or breach of contract (although the part of the decision that was concerned with interest as restitution of an unjust enrichment, which was the direct claim in question, was overruled by the Supreme Court in Prudential Assurance Co Ltd v HMRC). Sempra Metals was concerned with an award of compound interest (as damages or as restitution) which contrasts with the relevant statutes which allow awards of simple interest only. Less