What is a risk-free interest rate?
It is an interest rate for which the promised amount will certainly be paid.
Why are risk-free rates very important quantities for the derivative market?
- They are used to define the cash flows of several derivative products.
- They are very useful for many issues related to derivative pricing.
What are treasury rates?
- They are rates and yields on bonds issued by governments.
- They are risk-free rates.
- They are short and long maturities.
Why are treasury yields considered artificially low?
- They have a favorable tax treatment in the US that inflates prices of treasury bonds (artificially lower the yields).
- Banks don’t need to hold capital for investments in treasury bonds, whereas they do for other low-risk assets.
- Participants in the derivative markets rarely use them.
What is the London Interbank Offered Rate (LIBOR)?
- It is a rate at which a bank could borrow funds from another bank.
- It is a rate for institutions rated AA and above.
- Daily surveys of several financial institutions in London determine these rates.
- They are rates available for multiple maturities and currencies.
What is the Canadian Dollar Offered Rate (CDOR)?
It is the same thing as the LIBOR but in Canada,
What problems occurred with LIBOR rates after the 2007-2008 crisis?
- It had significant risk premiums associated with the possibility of bank default.
- The risk-free rate to value derivative was less present for that reason.
- There were problems regarding LIBOR manipulation.
What is a Repo rate?
- It is an agreement for the sale and repurchase of a risk-free security.
- The sale and the repurchase are defined at the signature of the agreement.
- It is a very short maturity.
How does a Repo rate work?
- The borrower sells a risk-free security to the lender and gets $$.
- The borrower repurchases the risk-free security from the lender some day later, but at a higher price.
- The interest is the difference between the sale and repurchase price.
Why is the Repo rate of very little credit risk?
- If the borrower does not respect the agreement, the lender keeps the risk-free security.
- If the lender does not respect the agreement, the borrower keeps the $$ borrowed.
What is a Secured Overnight Financing Rate (SOFR)?
- The SOFR rate is determined as an average of 1-day REPO rates in the US.
- Because of the very short term and because they are secured, they are default risk-free rates for a maturity of 1 day.
- It is a daily compounding rate expressed on an annual basis. The Federal Reserve Bank of New York publishes it every business day.
What is the Canadian Overnight Repo Rate (CORRA)?
- It is the SOFR, but in Canada.
- It is published by the Bank of Canada (BOC) every business day.
What is the importance of CORRA and SOFR?
- Regardless of their uncertainty, these rates will be used as reference rates for writing several forward and futures types derivative contracts.
- They are used as “raw material” to extract risk-free rates with maturities longer than one day.
What are the Overnight Indexed Swap rates (OIS)?
- It is a forward type of derivative product whose cash flows are determined from the SOFR and CORRA rates.
- They are used for OIS swap agreements for risk-free rates for both short and long maturities called OIS rates, and have been used since 2008.
What is a spot rate?
It is the yield to maturity of a zero-coupon bond.
What is the yield to maturity (YTM)?
It is a unique rate that makes the present value of future cash flows equal to the market value.
What is the par yield?
The coupon rate makes the present value of future cash flows equal to par value.
What is bootstrapping?
- It is the spot rate determination.
- It is used only for short maturities.
- This process can be used to determine longer maturities.
What is a forward rate?
It is the rate determined today for a loan starting at date t1 and maturing at date t2.
What is a Forward Rate Agreement (FRA)?
It is an agreement at t=0 to exchange an interest on an amount of L4 for a period starting at T1 and ending at T2.
Why do we use FRAs?
It is an instrument used to hedge against changes in interest rates.
What happens when we value a FRA after the inception date?
- The rate Rk is equal to the forward rate, guaranteeing a value of zero for the FRA contract at the inception date.
- After the inception date, the value of the FRA is different from zero.
Since 2007, which of the following is the risk-free rate?
It is the OIS rate.
